2010 Accounting, Financial Reporting, and Regulatory Update

2010 Accounting,
Financial Reporting, and
Regulatory Update
Financial Services Industry
Contents
Foreword
1
Section 1
Significant Accounting Developments 2
Consolidations/Transfers of Financial Assets
2
Loan Accounting
9
Accounting for Impairment and TDRs
11
Fair Value Measurements
18
Accounting for Financial Instruments — Effects of the FASB’s Proposed ASU
23
Financial Reporting Implications of the Dodd-Frank Wall Street Reform and Consumer Protection Act
34
Section 2
SEC Update and Hot Topics 39
Introduction
39
SEC Issues Various Proposed and Final Rules and Interpretations Affecting Financial Reporting
39
SEC Issues Proposed Rules Addressing Securities and Capital Markets
41
SEC Finalizes Rules Addressing Securities and Capital Markets
42
Recent Legislation
44
SEC Support of Convergence and Global Accounting Standards
45
Section 3
FASB and IASB Update
47
Introduction
47
FASB Accounting Standard Updates
47
Proposed FASB Accounting Standard Updates
56
Joint Projects of the FASB and IASB
58
IFRS Update
67
IASB Pending Projects
70
Section 4
Asset Management Sector Supplement
77
Asset Management Accounting Update
77
Regulatory Sector Supplement — Asset Management
90
Section 5
Banking and Securities Sector Supplement
Banking and Securities Accounting Update
96
96
Regulatory Sector Supplement — Banking
98
Regulatory Sector Supplement — Securities
106
Section 6
Insurance Sector Supplement
108
Insurance Accounting Update
108
Regulatory Sector Supplement — Insurance
113
i
Section 7
Real Estate Sector Supplement
119
Real Estate Accounting Update
119
Appendix A
Abbreviations 123
Appendix B
Glossary of Topics, Standards, and Regulations 126
Appendix C
Deloitte Specialists and Acknowledgments
133
Appendix D
Other Resources
Contents: Contents
136
ii
Foreword
December 2010
Those of us in the financial services industry have continued to experience challenges and opportunities as
a result of financial conditions both in the United States and abroad. To help you address such challenges,
we are pleased to present Deloitte’s annual Accounting, Financial Reporting, and Regulatory Update. We
hope you’ll find it useful as you enter your year-end reporting cycle.
This year’s edition outlines accounting, financial reporting, and regulatory updates that have occurred in
2010 and affect the financial services industry.
The first few chapters cover developments that are relevant to companies throughout the financial services
industry. Included are SEC, FASB, IASB, and financial reform updates as well as detailed commentary about
significant accounting developments.
The remaining chapters highlight insights targeted to the asset management, banking and securities,
insurance, and real estate sectors.
This year’s edition covers developments that took place through the beginning of the fourth quarter.
We hope you find it to be a useful resource, and we welcome your feedback. Please also visit us at
www.deloitte.com for more information, and watch for our Heads Up newsletter, to be issued in
mid-December, covering highlights from the 2010 AICPA National Conference on Current SEC and PCAOB
Developments.
As always, we encourage you to contact your Deloitte team for additional information and assistance.
Jim Reichbach
Vice Chairman, Financial Services
Deloitte LLP
Susan L. Freshour
Financial Services Industry Professional Practice Director
Deloitte & Touche LLP
1
Section 1
Significant Accounting Developments
Consolidations/Transfers of Financial Assets
Introduction
Over the past few years, the financial services industry has seen substantial changes in the accounting
for transfers of financial assets and consolidation of VIEs. In June 2009, the FASB issued Statement 166,
subsequently codified as ASU 2009-16, which amended Statement 140. The FASB concurrently issued
Statement 167, subsequently codified as ASU 2009-17, which amended Interpretation 46(R). Both ASUs
have significantly affected entities’ financial statements and business arrangements.
To recap, ASU 2009-16 removed the concept of a QSPE and required additional clarification about the
risks that a transferor continues to be exposed to because of its continuing involvement in transferred
financial assets. Furthermore, ASU 2009-17 replaced Interpretation 46(R)’s risks-and-rewards-based
quantitative approach to consolidation with a more qualitative approach that requires an entity to have
the “obligation to absorb losses of . . . or the right to receive benefits from the VIE that could potentially
be significant to the VIE” along with the “power to direct the activities of a VIE that most significantly
impact the VIE’s economic performance.”
When ASU 2009-17 was first issued, many reporting entities hoped that under the ASU’s more
qualitative approach, they would need to perform less analysis to determine whether an entity should
be consolidated. Reporting entities initially concentrated on understanding the effect that ASU 2009-17
would have on their former QSPEs, which would no longer be outside the scope of ASU 2009-17.
However, reporting entities have found that the initial adoption of ASU 2009-17 is more time-consuming,
since entities previously not deemed to be VIEs under Interpretation 46(R) are now considered VIEs under
the new guidance. For example, certain entities, such as limited partnerships that contained simple
majority kick-out rights to remove the general partner without cause, were not considered VIEs before the
adoption of ASU 2009-17. However, under the new guidance, the limited partnership could potentially be
a VIE if the kick-out rights are not unilaterally held by one party.
To lessen the burden for certain entities, on January 27, 2010, the FASB voted to finalize ASU 2010-10,
which deferred the effective date of ASU 2009-17 for a reporting entity’s interest in certain entities and
for certain money market mutual funds.1 ASU 2010-10 addressed concerns that (1) the joint consolidation
model under development by the FASB and the IASB may result in different consolidation conclusions
for asset managers and (2) an asset manager consolidating certain funds would not provide useful
information to investors.
Although the effects of ASU 2009-17 on ASC 810-10 and the financial services industry have received
the most media attention, the implications of ASU 2009-17 were felt in nearly every industry, including
energy and resources, hospitality and tourism, manufacturing, and retail. Specifically, the banking and
securities industries experienced a more than twelve-fold increase in the percentage of consolidated
VIE assets to total assets after the first quarter of 2010 (when adoption of the standard was required).2
This extraordinary increase in consolidated VIEs contributed to an assortment of implementation and
operational issues.
This section addresses key implementation issues, as well as some operational and financial statement
concerns, related to the adoption of ASU 2009-16 and ASU 2009-17. Some of the upcoming FASB and
IASB projects associated with these standards are also highlighted.
See Deloitte’s January 27, 2010, Heads Up, “FASB Votes to Finalize Deferral of Statement 167 for Certain Investment Funds.”
1
See Deloitte’s May 2010 report, “Back On-Balance Sheet: Observations From the Adoption of FAS 167.”
2
Section 1: Significant Accounting Developments
2
General Implementation Issues Related to ASU 2009-16
Some implementation issues have arisen as a result of ASU 2009-16’s introduction of the concept of
a participating interest. Many financial institutions transfer (participate) a portion of individual loans to
other financial institutions to limit credit risk or provide liquidity. Loan participations frequently contain
terms that entities must carefully evaluate to determine whether the transferred portions of a loan are
participating interests. ASU 2009-16 defined “participating interests” and clarified that sale accounting
is precluded for transfers of portions of financial assets that do not meet this definition. Entities must
evaluate transfers of portions of financial assets that meet the definition of a participating interest under
ASC 860-10-40-6A to determine whether derecognition under ASC 860-10-40-5 is appropriate.
Financial institutions often issue participations in loans they have originated, and entities look to the
guidance on transfers of financial assets to account for those transactions appropriately. To satisfy the
definition of a participating interest, transfers of financial assets must meet certain requirements, including
the following:
•
Pro rata ownership interest is in the entire asset transferred.
•
Proportionate division of all cash flows received from the underlying financial asset is in an
amount equal to the ownership share.
•
The rights of each participating interest holder have the same priority; no one interest holder’s
interest is subordinate to others.
•
No party has the right to pledge or exchange the underlying financial assets unless all
participating interest holders agree.
For example, consider the impact of the concept of participating interests on the accounting for transfers
involving asset-backed CP conduits. Generally, the transferor transfers financial assets to a bankruptcyremote entity that will then transfer assets, or interests in assets, to the CP conduit. If an entity transfers
a portion of trade receivables to a CP conduit, it must perform an analysis to determine whether the
interests transferred represent participating interests. In pro rata participation, the conduit and transferor
are each entitled to their specified portion of all cash flows collected.
Assume that trade receivables pool 1 and trade receivables pool 2 are transferred to a CP conduit. Each
pool has a par value of $50, and the $100 total value of assets purchased by the CP conduit is funded
with $80 of CP issued by the conduit. In an 80 percent pro rata participation, if $45 is collected on pool 1
and $5 is collected on pool 2, the CP conduit is entitled to $40 (80 percent of the total of $50 collected)
and the transferor receives $10 for its pro rata participation in the assets.
If all the criteria of a participating interest are met, the entity would derecognize the participating interest
only after performing the traditional sale accounting analysis.
General ASU 2009-17 Implementation Issues
One of the most arduous tasks entities faced in applying ASU 2009-17 was determining whether to
consolidate their VIEs.3 Before making this determination, entities needed to consider a series of other
issues.
See footnote 2.
3
Section 1: Significant Accounting Developments
3
This section highlights some of the key implementation issues associated with ASU 2009-17 that have
arisen over this past year and includes discussion of the following questions:
•
Does the entity qualify for the FASB’s recently issued deferral?
•
How does the entity now evaluate the service provider fees in determining the primary
beneficiary?
•
What are the most significant activities of the VIE?
•
Is the entity the primary beneficiary of the VIE under the new requirements?
•
What is the effect of kick-out rights in the new VIE consolidation analysis?
Does the Entity Qualify for the FASB’s Recently Issued Deferral?
ASU 2010-10 defers the application of ASU 2009-17 for a reporting entity’s interest in an entity if all the
following conditions are met:
•
The entity either (1) has all of the attributes specified in ASC 946-10-15-2(a)–(d)4 or (2) is an entity
whose industry practice is to apply guidance that is consistent with the measurement principles in
ASC 946 for financial reporting purposes.
•
The reporting entity does not have an obligation to fund losses of the entity that could potentially
be significant to the entity. In evaluating this condition, entities should consider implicit or explicit
guarantees provided by the reporting entity and its related parties, if any.
•
The entity is not a securitization entity, an asset-backed financing entity, or an entity that was
formerly considered a QSPE.
Examples of entities that may satisfy the conditions of the deferral include, but are not limited to, mutual
funds, hedge funds, private equity funds, mortgage real estate investment funds, and venture capital
funds. The FASB noted that the examples in the implementation guidance in ASU 2009-17 would not be
modified as a result of the ASU’s amendments and that an entity whose characteristics are consistent with
the characteristics of a VIE outlined in ASU 2009-17’s implementation guidance should not be subject to
the deferral.5
How Does the Entity Now Evaluate the Service Provider Fees in Determining the Primary
Beneficiary?
One topic that received much attention involved service providers (e.g., fund managers, master servicers)
and how to evaluate whether the fee they received that was identified as a variable interest under
ASC 810-10-55-37 would be potentially significant under ASC 810-10-25-38A(b). The consensus was
that it would depend on which of the six criteria in ASC 810-10-55-37 caused the fee to be a variable
interest, the quantitative criteria in (c), (e), or (f) or the more qualitative criteria in (a), (b), or (d). If the
quantitative conditions result in the fee’s being considered a variable interest (i.e., the anticipated fee
The attributes are as follows:
a. Investment activity. The investment company's primary business activity involves investing its assets, usually in the securities of other entities
not under common management, for current income, appreciation, or both.
b. Unit ownership. Ownership in the investment company is represented by units of investments, such as shares of stock or partnership interests,
to which proportionate shares of net assets can be attributed.
c. Pooling of funds. The funds of the investment company's owners are pooled to avail owners of professional investment management.
d. Reporting entity. The investment company is the primary reporting entity.
4
See footnote 1.
5
Section 1: Significant Accounting Developments
4
absorbs more than an insignificant amount of the expected residual returns of the VIE), the fee generally
would be presumed to be “potentially significant” under ASC 810-10-25-38A(b). However, if the more
qualitative conditions result in the fee’s being considered a variable interest (e.g., a loan servicer receives
a subordinate fee of 5 basis points, which is deemed to be a market-based fee at the time of the analysis,
and the servicer does not hold any other beneficial interests), that fee may not necessarily result in a
variable interest that is potentially significant to the VIE. A reporting entity generally must use judgment
in making such determinations, and the outcome of the analysis varies on the basis of the facts and
circumstances.
What Are the Most Significant Activities of the VIE? Is the Entity the Primary Beneficiary
of the VIE Under the New Requirements?
Many entities initially struggled with this new qualitative model and desired to apply thresholds or bright
lines to determine whether to consolidate a VIE. This desire to apply a more quantitative analysis was
fueled by the term “significant,” as used in ASC 810-10-25-38A(b) with respect to the determination of a
primary beneficiary. Questions arose about what amount or percentage would be considered significant
and about whether different thresholds were associated with significance and insignificance (the term
“insignificant” is introduced in the determination of whether a servicing fee is a variable interest under
ASC 810-10-55-37). As practice and guidance developed, entities began focusing more on the qualitative
aspects of their economic involvements rather than relying strictly on quantitative measures to determine
significance. The SEC suggested a need for both a qualitative and a quantitative analysis to support a
conclusion regarding significance. Arie S. Wilgenburg made the following remarks at the 2009 AICPA
Conference:6
[S]imilar to how we have talked in the recent past about materiality assessments being based on the
total mix of information, we believe that assessing significance should also be based on both quantitative and qualitative factors. While not all-inclusive, some of the qualitative factors that you might
consider when determining whether a reporting enterprise has a controlling financial interest include:
1. The purpose and design of the entity. What risks was the entity designed to create and pass
on to its variable interest holders?
2. A second factor may be the terms and characteristics of your financial interest. While the
probability of certain events occurring would generally not factor into an analysis of whether a
financial interest could potentially be significant, the terms and characteristics of the financial
interest (including the level of seniority of the interest), would be a factor to consider.
3. A third factor might be the enterprise’s business purpose for holding the financial interest. For
example, a trading-desk employee might purchase a financial interest in a structure solely for
short-term trading purposes well after the date on which the enterprise first became involved
with the structure. In this instance, the decision making associated with managing the
structure is independent of the short-term investment decision. This seems different from an
example in which a sponsor transfers financial assets into a structure, sells off various tranches,
but retains a residual interest in the structure.
As previously mentioned this list of qualitative factors is neither all-inclusive nor determinative and the
analysis for a particular set of facts and circumstances still requires reasonable judgment.
The next challenge was to determine the most significant activities of a VIE and who had the power over
those activities. This determination largely depended on the nature and design of the entity. For certain
entities, such as certain securitization structures involving beneficial interests in one type of collateral, the
analysis was fairly straightforward. For others, such as operating partnerships or joint ventures, the analysis
was contingent on the specific design and operations of the entity.
Speech by SEC Staff: Remarks before the 2009 AICPA National Conference on Current SEC and PCAOB Developments by Arie S. Wilgenburg,
December 7, 2009.
6
Section 1: Significant Accounting Developments
5
In addition, this analysis has been particularly challenging for arrangements in which one party is exposed
to the significant risks and rewards of a VIE yet does not appear to have the power to direct the most
significant activities of the VIE. The FASB added language to ASU 2009-17 that requires the exercise
of additional skepticism when the relative economic interests of the parties to an arrangement are
inconsistent with the stated power of each of these parties. Further, the SEC staff has publicly commented
on multiple occasions that it will scrutinize the accounting for arrangements that lack economic substance
or appear to be motivated by a desire to deconsolidate.
What Is the Effect of Kick-Out Rights in the New VIE Consolidation Analysis?
Also frequently debated was a question regarding a provision in ASU 2009-17 under which a single party
must be able to exercise kick-out rights, or participating rights, for these rights to be considered in the
consolidation analysis. In particular, one question that came up was whether the ability of the board of
directors to remove a manager or other party with power over the significant decision making would
be considered to be power held by a single party. A practice has emerged in which a board of directors
is an extension of the equity investors and therefore does not constitute a single party for ASU 2009-17
purposes unless a single equity investor (or related-party group of equity investors) controls representation
on the board of directors (i.e., has more than 50 percent representation on a board that requires a simple
majority vote, thereby indirectly controlling the board’s vote).
Operational Issues
Once entities identified which VIEs required consolidation, they soon focused on the operational aspects
of consolidation for the first time. The following are just a few of the operational challenges entities have
faced:
•
Need for additional dedicated resources.
•
Access to necessary financial information on a timely basis.
•
Need for development of additional internal controls.
Depending on the type of entity applying ASU 2009-17 and its involvements and variable interests held,
the implementation may have taken just a few days or it may have equated to many grueling hours with
a large number of dedicated resources (e.g., employees, consultants, auditors). For some companies,
the consolidation of new VIEs may have been simple enough to perform by using a spreadsheet tool.
For others, it may have involved significant systems modifications or upgrades to facilitate an expanded
consolidation process.
Another operational challenge that entities have been dealing with is access to the necessary financial
information on a timely basis. Many entities have used a reporting lag in consolidating their VIEs (i.e.,
they have used February VIE information for a March quarter-end consolidation) while monitoring for any
material events occurring during the lag period. ASC 810-10-45-12 states that it “ordinarily is feasible for
the subsidiary to prepare, for consolidation purposes, financial statements for a period that corresponds
with or closely approaches the fiscal period of the parent.” ASC 810-10-45-12 further states that as long
as the fiscal-year-end dates of the parent and subsidiary are not more than three months apart, it would
be acceptable to use the subsidiary’s financial statements for its fiscal period. Similarly, the SEC states that
the difference cannot be more than 93 days (see SEC Regulation S-X, Rule 3A-02) and that the entity must
disclose both the closing date for the subsidiary and the factors supporting the parent’s use of different
fiscal-year-end dates.
Section 1: Significant Accounting Developments
6
Although the guidance does not specify when different fiscal-year-end dates would be appropriate, a
parent should always be able to support its conclusion. For example, a calendar-year parent may have its
subsidiary use a November 30 year-end simply to ensure that the subsidiary’s financial information is fully
compiled, reliable, and available to include in the parent’s annual financial statements.
The parent should also evaluate material events occurring during any reporting time lag (i.e., the period
between the subsidiary’s year-end reporting date and the parent’s balance sheet date) to determine
whether the effects of such events should be disclosed or recorded in the parent’s financial statements.
Under ASC 810-10-45-12 and Regulation S-X, Rule 3A-02, “recognition should be given by disclosure
or otherwise to the effect of intervening events that materially affect the [parent’s] financial position or
results of operations.”7
Furthermore, securitization vehicles have historically been strictly cash flow vehicles and were never
required to prepare separate financial reports under U.S. GAAP. The creation of initial U.S. GAAP financial
statements for these entities, and the supporting footnote disclosures, presented another challenge and
required significant time and resources.
Public companies that are required to consolidate an entity may also face challenges from a SarbanesOxley control perspective to the extent that the financial information processing was outside their control
(i.e., the structure of CDOs or CLOs depended on trustee reports). Entities may have relied on SAS 70
reports or developed other control processes to gain sufficient comfort with the financial information.
The CAQ also recently issued an alert that provides the SEC staff’s views on ICFR requirements for entities
newly consolidated under ASU 2009-17. Such considerations include the requirement for companies to
consider ICFR for the consolidated entity. The SEC staff believes that registrants will most likely have the
right or authority to assess internal controls of the consolidated entity, and since consolidation will occur
as of the first day of the fiscal year, registrants will have sufficient time to perform such an assessment.
An entity can consider the following when assessing ICFR for newly consolidated entities:
•
Proper segregation of duties for financial reporting purposes.
•
Appropriate procedures for review of financial reporting packages.
•
Consistent application of accounting policies across reporting entities.
Financial Statement Presentation Issues
The measurement of assets and liabilities now presented on the balance sheet as a result of the
application of ASU 2009-17 has been another source of contemplation for preparers. Under the ASU,
an entity can choose, upon initial adoption, to measure the assets and liabilities being consolidated (1)
at their carrying amounts, (2) at the UPB for lending-related activities, (3) at their initial fair value (with
subsequent measurements based on the application of the relevant GAAP for those assets or liabilities),
or (4) by election of the FVO. Of a 40-entity sample, 43 percent selected the carrying amount, 23 percent
elected the FVO, 7 percent selected the UPB, and 27 percent elected a combination of methods.8 This
section will highlight a presentation issue that asset managers experienced this past year.
Many asset managers who consolidate CFEs will elect the FVO to mitigate the potential income statement
volatility that could occur under the carrying amount transition methods in ASC 810-10-65-2. Under those
methods, subsequent impairments on the assets held by a CFE would not be offset by recognition of
declines in fair value of the beneficial interests issued by the CFE.
For additional information, see 810-10-45 (Q&A 06), “Parent and Subsidiary With Different Fiscal-Year-End Dates” (available on Technical Library:
The Deloitte Accounting Research Tool).
7
See footnote 2.
8
Section 1: Significant Accounting Developments
7
Asset managers that have elected the FVO have generally concluded that upon initial adoption of ASU
2009-17, the aggregate fair value of the assets in the CFE exceeds the aggregate fair value of the CFE’s
beneficial interest (liabilities). Even though the liabilities are nonrecourse obligations, this situation may
occur as a result of the valuation premise and market participant guidance in ASC 820. In particular, the
market participant exit prices for the CFE’s beneficial interests often contain liquidity discounts that are not
inherent in the market participant exit prices for the CFE’s assets. In addition, there may not be a perfect
correlation between the duration of the assets and liabilities of the CFE.
Accounting for the excess of the fair value of the assets over the fair value of the liabilities of a CFE
presents a challenge and could result in the following effects on the financial statements of the
consolidated entity that includes the asset manager:
1. Upon initial adoption of ASU 2009-17, equity of the parent is increased by the excess of the
fair value of the CFE’s assets over its liabilities in accordance with the transition guidance in ASC
810-10-65-2(c).9
2. In subsequent financial reporting periods, the net change in fair value of the financial instruments
of the CFE would be reflected as income or loss of the consolidated entity that includes the asset
manager. Although the net change could be income or loss in any financial reporting period, the
net change over the remaining life of the CFE would result in a loss.
This way of accounting caused great concern for entities consolidating these structures, since the
financial reporting did not reflect the economics of the transaction and resulted in a presentation
difficult for investors to understand. Essentially, the above accounting would result in a consolidated
entity that includes all income and loss (and associated volatility) in its income statement for which it
is not economically exposed. That is, if the asset manager’s involvement with the CFE is limited to a
management fee, a portion (or all) of the CFE’s periodic net income or loss will have economic effects that
are either beneficial or detrimental to the third-party beneficial interest holders, but it would nevertheless
be reflected as net income or loss of the consolidated entity that includes the asset manager. In addition,
the reversal of the initial amount recorded to retained earnings (i.e., over time as the values of the assets
and beneficial interests converge) would result in the asset manager’s recognizing less income than its
actual management fees.
The question was raised with the staff of the SEC’s Office of the Chief Accountant. The staff
communicated that it would not object to an appropriation of retained earnings related to the transition
adjustment from adoption. In addition, the staff stated that it would object to exclusion, in future periods,
of any of the changes associated with these variable interest entities from the consolidated net income
or loss of the consolidated entity. However, the staff would not object to an appropriate attribution of
the periodic net income or loss between the asset manager (parent interests) and the beneficial interest
holders (noncontrolling interests) as an allocation to noncontrolling interest holders, with a corresponding
adjustment to the amount of the appropriated retained earnings.
For additional details on implementation and operational issues, see Deloitte’s May 2010 report, “Back
On-Balance Sheet: Observations From the Adoption of FAS 167.”
Looking Ahead — Convergence Project
The FASB and IASB have been jointly developing a comprehensive consolidation model for all entities
(both voting interest entities and VIEs). The basis for the consolidation focuses on control, which is defined
ASC 810-10-65-2(c) states, “Any difference between the net amount added to the balance sheet of the consolidating entity and the amount of any
previously recognized interest in the newly consolidated VIE shall be recognized as a cumulative effect adjustment to retained earnings.”
9
Section 1: Significant Accounting Developments
8
as having the following elements: (1) power over the entity, (2) exposure/rights to variable returns from its
involvement with the entity, and (3) the ability to use its power over the entity to affect the amount of the
reporting entity’s returns.
The IASB has completed its deliberations separately from the FASB and plans to issue a final standard by
the end of 2010. The FASB will consider U.S. stakeholder input on the IASB’s published staff draft and,
on the basis of this input, determine whether it will issue an ED that is consistent with the IASB’s final
standard.
Looking Ahead — Repurchase Transactions
The FASB is currently working on a project to improve the accounting for repurchase transactions by
amending the “effective control” criteria for transactions involving repurchase agreements or other
agreements that both entitle and obligate the transferor to repurchase or redeem financial assets before
their maturity. ASC 860 states that if a transferor maintains effective control over financial assets, it is
precluded from accounting for the transfer of financial assets as a sale; rather, it must account for the
transfer as a secured borrowing.
In particular, a transferor maintains effective control over transferred financial assets if there is a
repurchase agreement that both entitles and obligates the transferor to repurchase financial assets before
their maturity. ASC 860 also provides a criterion that indicates that a transferor maintains effective control
over a financial asset when the transferor is able to purchase or redeem the financial asset on substantially
agreed terms, even in the event of default by the transferee. To comply with this criterion, the transferor
must maintain cash or sufficient collateral to fund substantially all the cost of purchasing replacement
financial assets from others.
The FASB tentatively decided to remove this “cash collateral” criterion a transferor uses to determine
whether a transfer of financial assets within a repurchase agreement is to be accounted for as a sale or as
a secured borrowing. The Board has concluded its deliberations on this project and expects to issue an ED
in the fourth quarter of 2010.
Loan Accounting
Introduction — New Guidance
The FASB issued two ASUs in 2010 that affect registrants with loan receivable portfolios. On April 29, it
released ASU 2010-18, which provides guidance on whether an entity should remove a modified loan that
constitutes a TDR under ASC 310-40 from a pool of loans accounted for as a single asset under
ASC 310-30.
On July 21, the Board issued ASU 2010-20, which amends ASC 310 by requiring more robust and
disaggregated disclosures about the credit quality of an entity’s financing receivables and its allowance for
credit losses. The disclosure amendments apply to all entities with financing receivables, whether public
or nonpublic. A financing receivable is defined as a contractual right to receive money on demand, or on
fixed or determinable dates, that is recognized as an asset in the entity’s statement of financial position.
Examples of financing receivables include (1) loans, (2) trade accounts receivable, (3) notes receivable, (4)
credit cards, and (5) lease receivables (other than operating leases). The amended disclosure guidance
does not apply to short-term trade accounts receivable or receivables measured at (1) fair value, with
changes in fair value recorded in earnings, or (2) lower of cost or fair value. It also excludes from its scope
debt securities, unconditional promises to give, and beneficial interests in securitized financial assets.
Section 1: Significant Accounting Developments
9
Implementation Considerations
ASU 2010-18
ASU 2010-18 establishes that entities should not evaluate whether a modification of loans (that are part
of a pool accounted for under ASC 310-30) meets the criteria for a TDR in ASC 310-40. In addition,
modified loans should not be removed from the pool unless any of the criteria in ASC 310-30-40-1 are
met. Entities are allowed a one-time election to change the unit of accounting from a pool basis to an
individual loan basis. Such an election would be applied on a pool-by-pool basis. This would allow entities
that have elected to apply the guidance in ASC 310-40 on troubled debt restructurings to future loan
modifications. The ASU is effective prospectively for any modifications of a loan or loans accounted for
within a pool in the first interim or annual reporting period ending after July 15, 2010.
Registrants should be aware that the FASB’s proposed ASU on accounting for financial instruments (see
Section 3) contains a requirement to remove modified loans that constitute TDRs under ASC 310-40 from
a pool of loans, contrary to ASU 2010-18. Accordingly, entities may be required to change their practice in
the future if the proposed ASU is finalized as exposed.
ASU 2010-20
Under ASU 2010-20, at the portfolio segment level, an entity is only required to provide disclosures
about the allowance for credit losses related to financing receivables and qualitative information related
to modifications of financing receivables. The ASU defines a portfolio segment as the “level at which an
entity develops and documents a systematic methodology to determine its allowance for credit losses.”
For example, a portfolio segment may be defined by the different types of financing receivables (e.g.,
mortgage loans, auto loans), the industry to which the financing receivable relates, or the differing risk
ratings. All other disclosures required by the ASU are to be provided by class of financing receivable, which
is generally a disaggregation of a portfolio segment and is determined on the basis of the nature and
extent of an entity’s exposure to credit risk arising from financing receivables. At a minimum, classes of
financing receivables must be first (1) segregated on the basis of the measurement attribute (amortized
cost and present value of amounts to be received) and then (2) disaggregated to the level that an entity
uses when assessing and monitoring the risk and performance of the portfolio (including the entity’s
assessment of the risk characteristics of the financing receivables). For example, a loan portfolio may first
be disaggregated into classes on the basis of whether the loans were initially measured at amortized cost
or purchased credit impaired. The loan portfolio may then be further disaggregated into commercial,
consumer, and residential because such classes best reflect different risk characteristics and are consistent
with the method the entity uses to monitor and assess loan portfolio credit risk.
The ASU’s new and amended disclosure requirements focus on the following five topics: (1) nonaccrual
and past due financing receivables, (2) allowance for credit losses related to financing receivables,
(3) loans individually evaluated for impairment, (4) credit quality information, and (5) modifications. For a
detailed list of new and amended disclosure requirements see Deloitte’s July 22, 2010, Heads Up on ASU
2010-20. In preparation for their first filings under the new and amended disclosure requirements, entities
should consider any data collection issues that may arise as they gather information for reporting both
the period-end balances as well as the activity that occurs during a reporting period. Note, however, that
on December 9, 2010, the FASB issued a proposed ASU to defer the effective date in ASU 2010-20 for
disclosures about TDRs by creditors until the FASB finalizes its project on determining what constitutes a
TDR for a creditor (see the Accounting for Impairments and TDRs section below for more information on
this project). If redeliberations of both the proposed ASU and the Board’s TDR clarifications project go as
the Board expects, the deferral of ASU 2010-20 disclosures will only last a single quarter for public entities
Section 1: Significant Accounting Developments
10
with calendar year-ends. This is because the deferred disclosures will be reinstated as part of the TDR
clarifications project, which is expected to be effective for interim and annual periods ending after June
15, 2011, for public entities.
With respect to the effective date, for public entities, the new and amended disclosures about information
as of the end of a reporting period will be effective for the first interim or annual reporting periods
ending on or after December 15, 2010. That is, for calendar-year-end public entities, most of the new
and amended disclosures in the ASU would be effective for this year-end reporting season. However, the
disclosures that include information about activity that occurs during a reporting period will be effective
for the first interim or annual periods beginning after December 15, 2010. Those disclosures include
(1) the activity in the allowance for credit losses for each period and (2) disclosures about modifications
of financing receivables. For calendar-year-end public entities, those disclosures would be effective for the
first quarter of 2011.
For public entities that do not have a calendar-year-end, the effective date of the ASU becomes more
complicated. For example, a public entity that has a June 30 year-end would be required to provide the
new and amended disclosures about information as of the end of the reporting period in its financial
statements for the second quarter ended December 31, 2010. In addition, the new and amended
disclosures that include information about activity that occurs during a reporting period will be effective as
of the beginning of the public entity’s third quarter ended March 31, 2011 (i.e., January 1, 2011).
For nonpublic entities, all disclosures will be required for annual reporting periods ending on or after
December 15, 2011. That is, for calendar-year-end nonpublic entities, the new and amended disclosures
in the ASU would be effective for the next year-end reporting season. Comparative disclosure for earlier
reporting periods that ended before initial adoption is encouraged but not required. However, the ASU
requires entities to provide comparative disclosures for reporting periods that end after initial adoption.
Accounting for Impairment and TDRs
A recent Wall Street Journal article, “To Fix Sour Property Deals, Lenders ‘Extend and Pretend,’”10
highlights how some believe that loan modifications are being used to potentially defer losses. The
article notes that the “concern is that rampant modification of souring loans masks the true scope of the
commercial property market weakness, as well as the damage ultimately in store for bank balance sheets.”
Nevertheless, loan modifications are commonly used by banks and financial institutions as a strategy to
prevent foreclosure, make houses affordable to people in hardship, and mitigate losses in the long term.
Both residential and commercial loan restructurings are receiving significant attention lately, as the
credit crunch continues to affect the broader global economy. The article states that restructurings of
nonresidential loans stood at $23.9 billion at the end of the first quarter of 2010, more than three times
the level a year earlier and seven times the level two years earlier. The increase in the number of loan
modifications and workouts11 has raised concerns about whether changes to current accounting guidance
are needed to help lenders account for TDR12 and especially to help them determine whether a loan
modification is a TDR and how to measure the impairments.
Carrick Mollenkamp and Lingling Wei, “To Fix Sour Property Deals, Lenders ‘Extend and Pretend,’” Wall Street Journal, July 7, 2010.
10
One common loan modification program is the U.S. Treasury’s Home Affordable Modification Program (HAMP).
11
A loan modification may be accounted for as a TDR if both (1) the debtor is experiencing financial difficulties and (2) for economic or legal reasons,
a creditor grants a concession (i.e., the borrower’s effective borrowing rate on the modified loan is less than the effective rate of the loan before the
modification) to a debtor that it would not otherwise consider.
12
Section 1: Significant Accounting Developments
11
The discussion below reviews some basics of TDR accounting under existing U.S. GAAP and addresses
accounting developments in TDR and impairment that took place in 2010.
TDR Decision Tree
Is the debtor
experiencing
financial
difficulty?
ASC 470-60-55-7–9
Yes
No
The modification is not a TDR
and should be accounted for
under ASC 310-20, ASC 31020-35-11 and ASC 470-50.
No
Is the
modification more
than minor according
to ASC 310-20-35-11?
Did the
company grant a
concession?
No
Continuation of old loan.
Carry forward previous basis
adjustments.
ASC 310-20-35-10
ASC 470-60-55-11–14
ASC 310-20-35-11
Yes
Yes
Extinguishment of old loan
and recognition of new loan.
Recognize into income any
previous basis adjustments
and defer any new fees or
costs.
What type of
TDR does the
modification fall
under?
Receipt of assets in full
satisfaction of the loan.
Modification of the
loan terms.
ASC 310-40-40-2-4
ASC 310-40-35-5
Recognize a
gain or loss on
restructuring.
Measure for
impairment as
per ASC 310-10.
ASC 310-20-35-9
The following diagram (presented from the perspective of a creditor) is intended to help entities determine
when loan modifications are considered TDRs and what related accounting guidance they should apply.
Under current accounting guidance, when a loan modification is deemed a TDR, the financial institution
must recognize an impairment charge in earnings, calculated on the basis of the difference between
the present value of the modified cash flows, by using the EIR of the original loan and the financial
institution’s recorded investment in the loan. Under this approach, the impairment charge would not
necessarily reflect the full fair value deterioration of the loan because the impairment does not take
Section 1: Significant Accounting Developments
12
into account the fair value of the loan or the fair value of the underlying mortgage property. Thus, a
modification of the terms of a loan may sometimes have far less of an effect on the financial statements
than the true fair value deterioration of the loan. In addition, a creditor may avail itself of a practical
expedient. As indicated in ASC 310-10-35-22, “as a practical expedient, a creditor may measure
impairment based on a loan’s observable market price, or the fair value of the collateral if the loan is a
collateral dependent loan.”
Financial institutions may modify loans for numerous reasons and in numerous ways. In accordance
with ASC 470-60, no single characteristic or factor can be used alone in the determination of whether
a modification is a TDR. In addition, because there is inadequate implementation guidance on loan
impairments, the identification of TDRs can involve subjectivity. Furthermore, ASC 310-40-15-9 notes
that TDRs can take a variety of forms and accordingly the industry practice of applying U.S. GAAP varies
among financial institutions and lacks consistency. As a result, there are significant accounting and audit
risks in the application of TDRs and impairments, and in 2010 the industry continues to face the challenge
of assessing whether a modification represents a TDR.
Three areas in which financial institutions commonly experience difficulty in the implementation of TDR
accounting under U.S. GAAP are (1) identification of TDRs by lenders, (2) impairment methods, and (3)
income recognition on impaired loans.
Identification of TDRs by Lenders
On July 14, 2010, the FASB added a project to its agenda to provide additional implementation guidance
to assist lenders in determining whether a loan modification constitutes a TDR. The addition of this project
to the FASB’s agenda was in response to concerns raised by certain constituents, including the SEC and
banking regulators, that such guidance was warranted given the significant increases in loan modifications
being made by lenders in the current economic environment.
On October 12, 2010, the FASB issued a proposed ASU, Clarifications to Accounting for Troubled Debt
Restructurings by Creditors, to help lenders achieve more consistent identification of TDRs. The proposed
ASU would be effective for interim and annual periods ending after June 15, 2011. Retrospective
application would be required for certain disclosures (see further discussion below on the effect of the
proposed ASU on disclosures). Comments on the proposed ASU are due by December 13, 2010.
The proposed ASU clarifies the current accounting framework for TDRs. The discussion below focuses on
how the FASB’s proposed changes to TDR accounting address the implementation challenges related to
(1) when a modification constitutes a concession, (2) the concept of “financial difficulty,” (3) the concept
of “insignificant delay” in payment or shortfall of amount, and (4) updated disclosure requirements.13
When a Modification Constitutes a Concession
Identifying TDRs is complicated by the fact that under U.S. GAAP, different approaches are used for
creditors and debtors to identify whether a concession has been granted. Debtors are directed to use an
effective rate test under which the original EIR is compared with the postmodification EIR.
In contrast, under U.S. GAAP there are examples of TDRs for creditors, but a concession test is not
required. In fact, in the FASB’s proposed ASU, the Board stated that the effective rate test is only meant to
be used by the debtor. Creditors would need to consider whether a reduction in the EIR of the debt was
made to reflect a decrease in market rates or to grant a concession. For example, the lender may reduce
the interest rate on a loan primarily to reflect a decrease in market interest rates to maintain a relationship
For more information, see Deloitte’s October 15, 2010, Heads Up.
13
Section 1: Significant Accounting Developments
13
with a borrower that can readily obtain a loan from another lender under similar loan terms. This would
not be considered a TDR. Financial institutions face the challenge of creating an effective policy to
identify when a concession is considered granted. It can be particularly difficult to determine whether the
modified terms are at or above market terms (not a concession) or below market terms (a concession)
when there are no active markets to refer to. In response to these and other similar challenges, the FASB’s
proposed ASU provides the following clarifications:
•
Creditors should be explicitly precluded from using the borrower’s effective rate test in their
evaluation of whether a loan is a TDR.
•
A situation in which a market interest rate is not readily available is a strong indicator that the
modification was executed at a rate that is below market and that a concession may have been
granted.
•
A modification that results in a temporary or permanent increase to the contractual interest rate
cannot be presumed to be at a rate that is at or above market.
The Concept of Financial Difficulty
Numerous factors indicate that a debtor is experiencing financial difficulty. ASC 470-60-55-8 notes that
these factors can include:
•
Default.
•
Bankruptcy.
•
Doubt about whether the debtor will continue as a going concern.
•
Delisting of securities.
•
Insufficient cash flows to service debt.
•
Inability to obtain funds from other sources at a market rate for similar debt to a nontroubled
borrower.
Lenders must exercise professional judgment in assessing financial difficulty, which can lead to diversity in
practice. For example, credit score and valuation of underlying collateral are both acceptable approaches
to identifying financial difficulty within the existing accounting framework established by the FASB.
The FASB’s proposed ASU clarifies the concept of “financial difficulty.” Recent interagency regulatory
interpretive guidance makes a useful distinction between borrowers that are experiencing financial
deterioration and those that are experiencing financial difficulty. According to an August 25, 2010, Board
meeting handout, the focus of the regulatory guidance is that a borrower’s inability to service debt is a
primary indicator of financial difficulty. Accordingly, a borrower that is not currently in default may still be
experiencing financial difficulty (i.e., default may be probable even if all contractual payments are being
made as scheduled. For example, a borrower with an adjustable rate mortgage (ARM) loan may make all
of its scheduled payments when a loan is still at its “teaser” rate. Nonetheless, it is not uncommon for a
creditor to modify the terms of an ARM to reduce the forthcoming rate increase. Although in this example
it appeared that the borrower was not in financial difficulty because it made timely payments, the lender
may decide that default is probable in the foreseeable future (i.e., financial difficulty exists) on the basis of
each debtor’s individual circumstances.
Section 1: Significant Accounting Developments
14
The Concept of Insignificant Delay in Payment or Shortfall of Amount
When lenders determine whether a concession has been made, they consider whether the modification
results in an insignificant delay in payments or a shortfall of amount. In accordance with ASC 310-10-3517, forms of loan workouts that result in an insignificant delay in the amount of payments contractually
due to the organization are not typically considered TDRs and thus are not subject to an individual
impairment evaluation.
For instance, certain loans may be in short-term forbearance arrangements14 in which the duration of the
forbearance period and the shortfall in amount of payments would not significantly affect the effective
yield expected to be collected on the original loan. Although the effective yield may decrease by a small
amount, the entity may conclude that this change is insignificant. Conversely, any form of loan workout
that results in a more-than-insignificant delay or shortfall in amount with regard to the contractually due
payments by the borrower is subject to impairment recognition, measurement, and disclosure criteria.
The FASB’s proposed ASU indicates that a creditor should not conclude that a modification is not a TDR
simply because it results in a delay in payment or shortfall of payment amount. Under the proposed ASU,
entities must exercise judgment in determining whether a delay in payment or shortfall in the amount of
payments is more than insignificant. Institutions should consider the facts and circumstances of the form
of workout arrangement in reaching this conclusion.
Updated Disclosure Requirements
Because significant judgment is so pervasive in the accounting for troubled assets, institutions should
consider whether their MD&A and other disclosures related to troubled assets are sufficiently clear in
explaining how the institution accounts for those assets. Some questions that should be asked in this
process include the following:
•
Have I disclosed my policy for identifying loans to be restructured?
•
Do my disclosures make clear to readers the process I use to determine whether a loan
modification represents a TDR or some other form of modification?
•
Have I discussed and quantified the types of concessions granted on TDRs and the related
redefault rate by type of concession?
•
Have I disclosed information such as the redefault rate on renegotiated loans, the percentage of
accrual and nonaccrual TDRs, and other information that provides investors and regulators with
the success level of my renegotiation efforts?
•
Do my disclosures explain how specific trends (e.g., an increase in the number of delinquent
loans) have affected my allowance for loan losses?
•
Do my disclosures explain how I consider property appraisals, including any adjustments to dated
appraisals, in the determination of my allowance for loan losses?
•
Do my disclosures make clear the composition and asset quality of my loan portfolios (e.g.,
geographic concentrations, fixed vs. floating, jumbo vs. conforming)?
An arrangement providing a temporary reduction or suspension of payment on a borrower’s mortgage loan, followed by an arrangement to cure
the delinquency. The borrower may or may not be making payments during the forbearance plan. Servicers typically enter into a verbal forbearance
agreement with the borrower with the expectation that the borrower is incurring temporary difficulty in making payments but will be able to catch
up over a shorter period.
14
Section 1: Significant Accounting Developments
15
•
Do I sufficiently understand how I determine when a loan is placed on nonaccrual status or
what my company’s policy is for returning a loan to accrual status (e.g., how many payments a
borrower must make before returning to accrual status)?
•
Have I clearly disclosed any changes to my business policies and procedures that were made to
minimize defaults (e.g., number or size of loans originated)?
•
Have I made the appropriate disclosures for loan commitments that are accounted for off
balance sheet?
Recently, a number of companies received SEC comment letters regarding TDRs, nonperforming loans,
and nonaccrual status. These comments are consistent with the FASB’s recently issued ASU 2010-20
in that the comments call for enhanced disclosures that facilitate financial statement users’ evaluation
of credit risks and allowance for credit losses for an entity’s portfolio of financing receivables. Areas
affected by the ASU include (1) the credit quality of receivables, (2) the allowance for loan losses, (3)
impairment and accrual or nonaccrual status of loans, and (4) loan modifications. The ASU also requires
some new disclosures, including (1) qualitative information about the type of modifications undertaken
and the financial impacts thereof, (2) Information on how an organization determines to place a loan on
nonaccrual status, and (3) information on how an organization recognizes interest income on impaired
loans.
For public entities, the new and amended disclosures required by ASU 2010-20 that relate to information
as of the end of a reporting period will be effective for the first interim or annual reporting periods
ending on or after December 15, 2010. That is, for calendar-year-end public entities, most of the new
and amended disclosures in the ASU would be effective for this year-end reporting season. However,
the disclosures that include information for activity that occurs during a reporting period will be effective
for the first interim or annual periods beginning after December 15, 2010. Those disclosures include (1)
the activity in the allowance for credit losses for each period and (2) disclosures about modifications of
financing receivables. For calendar-year-end public entities, those disclosures would be effective for the
first quarter of 2011.
Impairment Methods
In accordance with ASC 310-10-35-22, when a restructured loan qualifies as a TDR, or a loan is considered
individually impaired, impairment should be measured on the basis of one of the following three methods:
•
The present value of expected cash flows discounted at the loan’s original EIR.
•
The loan’s observable market price.15
•
The fair value of the underlying collateral, as a practical expedient, if the loan is considered
collateral dependent.16
For most TDRs, the present value of expected future cash flows is the method to use because the loans
are not collateral dependent upon modification, and obtaining a market price for the loan is usually not
practicable. If entities measure impairment by using an estimate of the expected future cash flows, the
interest rate used to discount the cash flows is the EIR based on the original contractual rate and not the
rate specified in the restructuring agreement. Because U.S. GAAP does not specify an order of impairment
Note that the use of a fair value measure in determining loan impairment may cause significantly different impairment results than does a present
value approach that uses expected cash flows.
15
If either the observable market price or collateral dependent methods are used in measuring impairment, fair value disclosures under ASC 820-10
may be required and thus an entity will review for these potential disclosures.
16
Section 1: Significant Accounting Developments
16
methods for entities to use, they follow the method that is most consistent with reasonable expectations
for the recovery of their recorded investment in the loan.
ASC 310-10-35-26 states, in part:
If a creditor bases its measure of loan impairment on a present value calculation, the estimates of
expected future cash flows shall be the creditor’s best estimate based on reasonable and supportable
assumptions and projections. All available evidence, including estimated costs to sell if those costs are
expected to reduce the cash flows available to repay or otherwise satisfy the loan, shall be considered
in developing the estimate of expected future cash flows.
Note that the estimate of expected cash flows is based on the creditor’s judgment and may differ from
what is received in the future. In addition, estimates could change dramatically with changes in the
market or credit worthiness of a borrower. Therefore, present value estimates should be revisited regularly.
However, ASC 310-10-35-32 notes that regardless of the original measurement method, when it becomes
probable that the organization will foreclose on a loan, impairment should be measured by comparing
the entity’s recorded investment in the loan to the fair value less cost to sell of the underlying collateral.
Once a company looks to the collateral value to determine impairment on a restructured loan, it should
continue to look to the collateral value to quantify impairment when foreclosure is considered probable.
Determining that foreclosure will most likely occur is difficult for many creditors. Therefore, it is important
for organizations to continuously assess loans that are, or may become, probable of foreclosure.
In the current economic environment, many loans are susceptible to foreclosure, and changes in the
expected cash flows are very common. In accordance with ASC 310-10-35-37, after the initial impairment
measurement, management should reassess the impairment on the loan by applying a net present value
method based on the expected cash flows. Further, the entity may decide to change the impairment
method, such as when a loan becomes probable of foreclosure. Thus, changes in the valuation allowance
can result from changes (i.e., in timing or amount) of expected future cash flows of the impaired loan,
actual cash flows that differ from previous projections, or changes in circumstances that would suggest an
institution will not recover all expected future cash flows associated with the impaired loan on the basis of
the restructured terms (i.e., foreclosure is probable or if the underlying collateral is significantly damaged).
Income Recognition on Impaired Loans
Even after a financial institution determines a loan is a TDR and records the associated impairment, it is
faced with the challenge of determining when to change a loan’s status from nonaccrual to accrual.
Typically, once a loan’s principal or interest is no longer reasonably assured of collection, the loan is placed
on nonaccrual status, and any subsequent interest accruals are not recognized. Therefore, loans subject to
a modification or restructuring of terms in a TDR represent troubled loans that most likely were placed on
nonaccrual status before the modification.
Under U.S. GAAP, there is no specific guidance on whether a loan that has been modified in a TDR should
be classified as nonaccrual or returned to accrual status. General revenue recognition guidance under U.S.
GAAP, however, states that an entity should not recognize income unless it is both earned and realizable.
The Office of Thrift Supervision17 recommends that loans should remain on nonaccrual status until the
borrower has demonstrated a willingness and ability to make the restructured loan payments.18 Examples
of loans that may demonstrate willingness and ability to make restructured payments include those with
The Office of Thrift Supervision is the primary regulator of all federal and many state-chartered thrift institutions, which include savings banks and
savings and loan associations.
17
Office of Thrift Supervision, Thrift Bulletin 85, “Regulatory and Accounting Issues Related to Modifications and Troubled Debt Restructurings of 1-4
Residential Mortgage Loans.”
18
Section 1: Significant Accounting Developments
17
evidence of sustained performance such as a borrower’s timely payments of principal and interest for a set
number of months.
Note that it is not always appropriate to assume that a loan can return to accrual status immediately
after its restructuring. For example, recent evidence has been seen from results of the Home Affordable
Modification Program (HAMP), whereby a significant number of loans restructured under the program
have defaulted again after modification, thus indicating that modification alone does not always suggest
that principal and interest will be reasonably assured of collection. Although the HAMP program provides
a trial period to evaluate the borrower’s willingness and ability to make payments, all future payments
may not be reasonably assured. Therefore, companies must be cautious when creating a policy for the
return of modified loans to accrual status.
TDRs were also a hot topic on the agenda at the AICPA’s 2010 Banking Conference. One of the takeaways
from the conference was that a majority of loan modifications are TDRs in nature and that financial
institutions need to be careful in determining whether a modification is in fact a TDR because a TDR
designation cannot subsequently change, as emphasized by the adage “once a TDR, always a TDR.”
Fair Value Measurements
The issuance of Statement 157 (codified in ASC 820) four years ago led to a significant amount of
discussion about its implementation in a turbulent market (and to the issuance of additional guidance),
which has begun to settle during the past year. In addition, efforts to converge the fair value standards
of the FASB with those of the IASB continue. For more details on the FASB and IASB joint project on
fair value measurements, see Section 3. This section discusses both the FASB’s guidance on fair value
disclosure requirements and other fair value measurement guidance.
Fair Value Disclosure Update
ASU Improves Disclosures About Fair Value Measurements
Last year’s Financial Services Industry update discussed the FASB’s proposed ASU to enhance the
disclosures related to fair value measurements. After considering comment letters and engaging in further
deliberation, in January 2010 the FASB issued ASU 2010-06, which added to ASC 820 requirements for
disclosures about transfers into and out of Levels 1 and 2 and for separate disclosures about purchases,
sales, issuances, and settlements related to Level 3 measurements. ASU 2010-06 also clarifies existing
fair value disclosure requirements related to the level of disaggregation and to the inputs and valuation
techniques used to measure fair value. The key changes this ASU makes to fair value disclosure guidance
are summarized below.
Unlike the proposed ASU, the final ASU does not require entities to provide sensitivity disclosures.19 The
FASB decided to exclude this requirement from the final ASU in view of comments it received during the
exposure period about the operationality and cost of such disclosures and its October 2009 decision to
converge its guidance with the IASB’s on fair value measurement and disclosure. The FASB is considering
whether to require sensitivity disclosures jointly with the IASB as part of their convergence project. In
June 2010, the FASB issued a proposed ASU, Amendments for Common Fair Value Measurement and
Disclosure Requirements in U.S. GAAP and IFRSs, which reintroduced the sensitivity analysis requirement.
See Section 3 for further discussion of this ASU.
Under the proposed ASU, for Level 3 fair value measurements, if changing one or more of the significant unobservable inputs to reasonably possible
alternative inputs would have changed the fair value significantly, entities would have been required to state that fact and disclose the total effect
of those changes. In addition, entities would have been required to describe how the effect of a change to a reasonably possible alternative input
was calculated. The proposed ASU also suggested that an entity disclose, for each class of Level 3 measurements, quantitative information about the
significant inputs used and reasonably possible alternative inputs.
19
Section 1: Significant Accounting Developments
18
Level of Disaggregation
Before the amendments made by ASU 2010-06, the guidance in ASC 820 required entities to provide fair
value measurement disclosures by “major category of assets and liabilities.” The term “major category”
has often been interpreted to refer to a line item in the statement of financial position. The ASU amends
ASC 820 to require entities to provide fair value measurement disclosures for each class of assets and
liabilities. Disclosure “by class” may be more useful since a class is often a subset of assets or liabilities
within a line item in the statement of financial position. When providing disclosures for equity and
debt securities, entities should determine class on the basis of the nature and risks of the securities, in
a manner consistent with ASC 320-10-50-1B and, if applicable, ASC 942-320-50-2. Under ASC 320-1050-1B, in determining the nature and risks of the securities, entities should consider activity or business
sector, vintage, geographic concentration, credit quality, and economic characteristics. ASC 942-320-50-2
requires financial institutions to disclose all of the following major security types (additional types may be
necessary):
•
•
•
•
Equity securities, segregated by any one of the following:
o
Industry type.
o
Entity size.
o
Investment objective.
Debt securities issued by:
o
U.S. Treasury and other U.S. government corporations and agencies.
o
States of the United States and political subdivisions of the states.
o
Foreign governments.
o
Corporations.
Mortgage-backed securities, including:
o
Residential.
o
Commercial.
Debt obligations, including:
o
Collateralized.
o
Noncollateralized.
For all other assets and liabilities, entities should use judgment to determine the appropriate classes of
assets and liabilities for which they should provide disclosures about fair value measurements.
Under ASU 2010-06, when determining the appropriate classes of its assets and liabilities, an entity
must consider the nature and risks of the assets and liabilities as well as their placement in the fair value
hierarchy (i.e., Level 1, 2, or 3). For example, a greater number of classes may be necessary for fair value
measurements with significant unobservable inputs (i.e., Level 3 measurements) because of the increased
uncertainty and subjectivity involved in these measurements.
Section 1: Significant Accounting Developments
19
In determining the appropriate level of disaggregation, an entity should also consider what is required for
specific assets and liabilities under other GAAP (e.g., the disclosure level required for derivative instruments
under ASC 815).
Questions have arisen about whether, when this guidance is applied to derivative contracts, the level
of disaggregation for disclosures under ASC 820 (as amended by ASU 2010-06) is the same as that for
disclosures under ASC 815. Consequently, questions have arisen about how the term “class,” as discussed
in ASC 820, compares with the term “type of contract” used for the ASC 815 tabular disclosures. In
supporting its judgments about the determination of class for its derivative contracts, a reporting entity
should consider the type of derivative contracts it holds (i.e., the level of disaggregation required for
the ASC 815 tabular disclosures). However, as described in ASC 820-10-50-2A, class is based on the
nature and risks of the derivatives and their classification in the hierarchy and is often determined at a
greater level of disaggregation than the reporting entity’s line items in the statement of financial position.
Therefore, in determining the nature and risks of its derivative contracts, a reporting entity should consider
the following factors (in addition to type of contracts): the valuation techniques and inputs used to
determine fair value, the classification in the fair value hierarchy, and the level of disaggregation in the
statement of financial position. A reporting entity may also consider the level of disaggregation it uses for
other ASC 815 disclosures (e.g., qualitative and volume), which may vary from the level of disaggregation
it uses for the ASC 815 tabular disclosures.
For equity and debt securities, ASC 320-10-50-1B provides guidance on class determination and
provides useful general considerations for assessing nature and risks. On the basis of these requirements,
concentrations are likely to be key considerations in the class determination for all assets and liabilities
within the scope of the ASU. For example, a reporting entity that engages in material commodity
transacting may consider concentrations in areas such as commodity type, or a reporting entity with a
material foreign exchange portfolio may consider concentrations by discrete currencies.
In summary, the classes of derivative contracts under the ASC 820 disclosures may differ from the “type of
contracts” used for the ASC 815 tabular disclosures. Depending on the facts and circumstances, class may
be more disaggregated than type of contract, but it generally should not be more aggregated.
Transfers Into and Out of Levels 1, 2, and 3
Before the effective date of ASU 2010-06, ASC 820 only required disclosures about transfers into and
out of Level 3 for recurring fair value measurements as part of the Level 3 reconciliation of beginning and
ending balances. The ASU 2010-06 amendments expand these disclosure requirements to include all three
levels of the fair value hierarchy. More specifically, for assets and liabilities that are measured at fair value
on a recurring basis in periods after initial recognition, the ASU requires an entity to disclose the amounts
of “significant”20 transfers between Levels 1 and 2, and transfers into and out of Level 3, of the fair value
hierarchy and the reasons for those transfers. An entity must disclose and discuss significant transfers into
each level separately from transfers out of each level. For this purpose, significance is judged with respect
to earnings and total assets or total liabilities or, when changes in fair value are recognized in other
comprehensive income, with respect to total equity. In addition, an entity should disclose and consistently
follow its policy for determining when transfers between levels are recognized (e.g., as of the (1) actual
date of the event or change in circumstances that caused the transfer, (2) beginning of the reporting
period, or (3) end of the reporting period). The entity’s policy for transfers into Levels 1, 2, and 3 should
be the same as that for transfers out of Levels 1, 2, and 3.
The FASB’s proposed ASU Amendments for Common Fair Value Measurements and Disclosures Requirements in U.S. GAAP and IFRSs, issued in June
2010, amends the disclosure requirement to include any transfers between Level 1 and Level 2 of the fair value hierarchy. See Section 3 for further
discussion of this ASU.
20
Section 1: Significant Accounting Developments
20
Reconciliation on a Gross Basis
The ASU amends the reconciliation of the beginning and ending balances of Level 3 recurring fair value
measurements. In periods after initial recognition, an entity presents information about purchases, sales,
issuances, and settlements for significant unobservable inputs (Level 3) on a gross basis (i.e., each type
separately) rather than as a net number as previously required. Financial statement users have indicated
that gross presentation is more useful.
Disclosures About Inputs and Valuation Techniques
ASU 2010-06 clarifies that a description of the valuation techniques (e.g., market approach, income
approach, cost approach) and inputs used to measure fair value is required for both recurring and
nonrecurring fair value measurements. In addition, such disclosures are required for fair value
measurements classified as either Level 2 or Level 3. If the valuation technique has changed, entities
should disclose that change and the reason for the change.
Upon implementation, various constituents have asked whether ASC 820 now requires entities to disclose
quantitative information about inputs. On the basis of the guidance in ASC 820-10-50-2(e), a reporting
entity is not required to disclose quantitative information about inputs. However, in many instances, a
reporting entity may conclude that such information is appropriate. This determination is based on the
reporting entity’s evaluation of what types of input disclosures enable financial statement users to assess
the entity’s valuation techniques and inputs. A reporting entity should prepare its disclosures about inputs
in accordance with ASC 820-10-50-2(e). In other words, the discussion of inputs is expected to vary by
class of assets or liabilities, level in the fair value hierarchy, and valuation technique(s) used. Likewise, we
believe that there should be some degree of consistency between the items discussed in the narrative
about inputs and valuation techniques and the class determination. For example, disclosure about inputs
specific to a certain commodity type (e.g., average tenor and geographic concentration for natural gas
positions) may suggest that the commodity type should represent a class of its own.
Effective Date and Transition
The guidance in the ASU is effective for the first reporting period (including interim periods) beginning
after December 15, 2009, except for the requirement to provide the Level 3 activity of purchases,
sales, issuances, and settlements on a gross basis, which will be effective for fiscal years beginning after
December 15, 2010, and for interim periods within those fiscal years. In the period of initial adoption,
entities will not be required to provide amended disclosures for any previous periods presented for
comparative purposes. However, those disclosures are required for periods ending after initial adoption.
Early adoption is permitted.
VRG Update
The Valuation Resource Group (VRG), the FASB’s advisory body on valuation-related issues, met in April
of this year to discuss practice issues associated with fair value measurement.21 At the April meeting, the
VRG discussed Issue 2010-01: the FASB/IASB joint project on fair value measurement and disclosure and
whether the tentative decisions reached as part of this project would represent a significant change in
practice or would result in unintended consequences. The VRG voiced concerns regarding some of the
tentative decisions — in particular, those on blockage factors. The following table summarizes (1) the
boards’ tentative decisions to date that the FASB staff believes will change the existing guidance in ASC
820 (though these decisions may not necessarily result in a change in practice) and (2) the VRG members’
discussion. For further discussion of related proposed guidance, see Section 3.
This document focuses only on topics discussed by the VRG that are significant to the financial services industry. For summaries of all issues discussed
at the April 12, 2010, VRG meeting, see Deloitte’s Heads Up on the meeting.
21
Section 1: Significant Accounting Developments
21
Subject
Tentative Board Decisions That Would
Change Existing Guidance in ASC 820
The principal
(or most
advantageous)
market
• The reference market for a fair value
measurement is the principal (or most
advantageous) market, provided that an entity
has access to that market.
• The principal market is the market with the
greatest volume and level of activity for the
asset or liability.
• The principal market is presumed to be the
market in which the entity normally transacts.
An entity does not need to perform an
exhaustive search for markets that might have
more activity than the market in which the
entity normally transacts.
VRG Members’ Discussion
Some VRG members expressed concern about
adding the access notion to the “principal or most
advantageous market” principle. They pointed out
that this could result in unintended consequences,
particularly when there is no or a limited market.
They also highlighted that a price in a market that
an entity does not have access to may nevertheless
be a relevant observable input that the entity could
consider in estimating fair value.
• The determination of the most advantageous
market takes into account both transaction
costs and transportation costs.
Market
participants
• In the description of market participants,
“independence” means that market
participants are independent of each other
(i.e., they are not related parties).
• A price in a related-party transaction may be
used as an input to a fair value measurement
if the transaction was entered into at market
terms.
• The unobservable inputs derived from an
entity’s own data, adjusted for any reasonably
available information that market participants
would take into account, are considered
market-participant assumptions and meet the
objective of a fair value measurement.
Highest and
best use
• The highest-and-best-use concept relates
only to nonfinancial assets, not to liabilities or
financial assets.
• The terms “physically possible,” “legally
permissible,” and “financially feasible” will be
defined.
VRG members expressed concern that the guidance
on related parties was circular. They pointed
out that to use the price from the related-party
transaction, an entity would have to prove it was at
market terms (in which case the entity would not
need the price from the related-party transaction).
Some VRG members indicated their belief that
the guidance on related parties should take into
account existing related-party literature, such as
ASC 850-10-50-5, which states, “Transactions
involving related parties cannot be presumed to be
carried out on an arm’s-length basis, as the requisite
conditions of competitive, free-market dealings
may not exist. Representations about transactions
with related parties, if made, shall not imply that
the related party transactions were consummated
on terms equivalent to those that prevail in arm’slength transactions unless such representations can
be substantiated.”
Some VRG members noted that, in certain
circumstances, nonfinancial assets can be bundled
as a group with financial instruments to offset the
risk of another asset or liability that is not measured
at fair value (e.g., an inventory purchase contract).
Some VRG members were concerned about
eliminating the in-use concept for financial
assets because it might lead to a conclusion that
investment companies cannot include control
premiums when valuing controlling interests in
portfolio companies.
The VRG also noted that more guidance on what is
considered a nonfinancial asset and liability would
be helpful.
Section 1: Significant Accounting Developments
22
Subject
Valuation
premise
Tentative Board Decisions That Would
Change Existing Guidance in ASC 820
• The concept of a valuation premise relates
only to nonfinancial assets, not to liabilities or
financial assets.
• The objective of measuring an individual asset
at fair value is to determine the price for a
sale of that asset alone, not for a sale of that
asset as part of (1) a group of assets or (2)
a business. However, when the highest and
best use of an asset is as part of a group of
assets, the fair value measurement of that
asset presumes that the sale is to a market
participant that has, or can obtain, the
“complementary assets” and “complementary
liabilities.” Complementary liabilities include
working capital but do not include financing
liabilities.
VRG Members’ Discussion
Many VRG members expressed concern that the
revisions to the guidance on groups of assets could
have significant implications for current practice,
cause unnecessary confusion, or both.
• The objective of the valuation premise will be
described without using the terms “in-use”
and “in-exchange” because those terms are
often misunderstood.
Premiums and
discounts in
a fair value
measurement
• Blockage factors will be clarified and a
description of how they differ from other
types of adjustments, such as a lack of
marketability discount, for an individual
instrument will be included.
• The application of a blockage factor will
be prohibited at any level of the fair value
hierarchy.
• There would be guidance specifying that a
fair value measurement in Levels 2 and 3 of
the fair value hierarchy takes into account
other premiums and discounts that market
participants would consider in pricing an asset
or liability at the unit of account specified in
the relevant standard (except for a blockage
factor).
VRG members thought that this was a significant
change in practice. Concerns were raised regarding
the use of the term “lack of marketability discount,”
since they did not believe this term was understood
in practice. This term has historically applied to
minority interests in privately held stocks. Some
VRG members voiced concern about the proposal
to preclude the consideration of blockage in Levels
2 and 3 of the fair value hierarchy. Some VRG
members noted that blockage discounts typically
apply to market transactions for assets that do not
relate to Level 1 fair value measurements (e.g.,
a fleet of cars). They believed that it would be
challenging to distinguish a blockage discount from
a liquidity and marketability discount.
Accounting for Financial Instruments — Effects of the FASB’s
Proposed ASU
Summary of the ED
For years, the FASB and IASB (the “boards”) have attempted to solve the mystery of accounting for
financial instruments. Their attempts have typically been made in response to pressure on their accounting
models exerted by new financial instrument products and more creative accounting schemes. Driven by
limitations in their models and the stress on financial markets due to the global financial crisis, the boards
joined efforts to develop a comprehensive reform of their models for financial instrument accounting.
On May 26, 2010, the FASB issued a proposed ASU on accounting for financial instruments, derivative
instruments, and hedging activities. Although creation of this ASU was one of the boards’ major
Section 1: Significant Accounting Developments
23
convergence projects, the models proposed by the FASB and IASB failed to converge. Nevertheless, the
boards intend to continue to work toward international convergence. This section focuses on the FASB’s
proposal and, in some instances, compares it with elements of the IASB’s proposal.
The proposed ASU contains a comprehensive new model of accounting for financial assets and financial
liabilities. If adopted as final, the FASB’s proposal would significantly affect the accounting for a broad
range of financial instruments, as outlined below. The proposal would affect all entities holding or issuing
financial instruments; however, the financial services industry would probably be the one must significantly
affected. Comments on the proposed ASU were due by September 30, 2010; for a summary of the nature
and content of the more than 2,600 comment letters received by the FASB, see the Comment Letters
section below.
Scope of the Proposed ASU
The proposed ASU applies to all entities and to all financial assets and financial liabilities that are not
specifically indicated as outside its scope. Types of financial assets and financial liabilities included within
the scope of the ASU include, but are not limited to:
•
Investments in debt securities (e.g., government and corporate bonds).
•
Investments in equity instruments (e.g., publicly traded equity securities and nonmarketable
equity investments, when the investor does not have significant influence over the investee).
•
Investments in equity securities, when the investor has significant influence over the investee but
the operations of the investee are unrelated to the investor’s consolidated operations.
•
Mutual fund investments.
•
Beneficial interests in securitized financial assets.
•
Loans (e.g., consumer loans, commercial loans, and mortgage loans).
•
Trade receivables and trade payables.
•
Deposit liabilities.
•
An entity’s own debt.
•
Derivative financial instruments (e.g., options, forwards, futures, and swap contracts).
The proposed ASU also identifies certain exceptions, such as employee stock options, interests in
consolidated subsidiaries (including equity investments and noncontrolling interests), instruments classified
in stockholders’ equity, pension obligations, most insurance contracts, lease assets, and lease liabilities.
For a more complete list of financial instruments that are outside its scope, see the proposed ASU on the
FASB’s Web site or Deloitte’s May 28, 2010, Heads Up.
Classification of Financial Instruments
Upon initial recognition, an entity would classify a financial instrument into one of the categories of
financial assets and financial liabilities identified in the proposed ASU and would not have the ability to
subsequently reclassify between categories. Financial instruments would largely be measured at (1) fair
value, with changes in fair value recognized in net income (FV-NI); (2) fair value, with certain changes in
fair value recognized in other comprehensive income (FV-OCI); or (3) amortized cost. These classification
Section 1: Significant Accounting Developments
24
categories would replace the classification categories for financial instruments under current U.S. GAAP
(e.g., held for trading, available for sale, held to maturity, and loans held for sale or held for investment).
For further details on classification specifications resulting from the ASU, refer to Table 1 below.
As mentioned above, the FASB’s proposal prohibits subsequent reclassification between categories.
This differs from the IASB’s proposal, which states that an entity that changes its business model must
reclassify its financial instruments and provide certain disclosures. For a summary of the differences
between the proposed ASU and the IASB’s proposal, see Table 2 below.
The default category for financial assets and financial liabilities within the scope of the proposed ASU
(other than core demand deposit liabilities and certain redeemable investments, as further discussed
below) is FV-NI. However, an entity is permitted instead to classify an asset or liability as FV-OCI or
amortized cost if it meets certain qualifying criteria, as discussed below. If classified as FV-OCI, the
instrument is measured at fair value, but certain specified changes in fair value are recognized in OCI
rather than in net income.
Classification as FV-OCI
As a result of the proposed changes, financial assets or financial liabilities that are debt instruments can be
classified as FV-OCI if (1) the asset or liability maintains certain cash flow characteristics,22 (2) the entity’s
business strategy for the instrument is to collect or pay the related contractual cash flows rather than to
sell the financial asset or to settle the financial liability with a third party, and (3) no embedded derivatives
exist that would otherwise require bifurcation under ASC 815-15.
This third requirement stems from the elimination of certain bifurcation requirements for contracts that are
within the scope of the proposed ASU (see further discussion in the Embedded Derivatives section below).
A hybrid financial instrument containing an embedded derivative that otherwise must be accounted for
separately from the host contract (in accordance with ASC 815-15) would not be allowed classification
under FV-OCI and would instead be measured in its entirety at fair value, with changes in fair value
immediately recognized in earnings.
Classification as Amortized Cost
An entity is permitted to classify short-term receivables and payables as amortized cost if they (1) arise
in the normal course of business, (2) are due in customary terms not exceeding one year, (3) meet the
FV-OCI classification criteria (see the Classification of FV-OCI section above), and (4) are not short-term
lending arrangements (e.g., credit card receivables or short-term debt securities). Financial assets other
than short-term receivables cannot be classified as amortized cost.
An entity may also elect to classify financial liabilities other than deposit liabilities as amortized cost if the
financial liability meets the criteria for FV-OCI classification and the measurement of the financial liability at
fair value would create or exacerbate an accounting mismatch.23
Fair value is considered to create or exacerbate an accounting mismatch only if (1) the financial liability is contractually linked to an asset measured
at amortized cost (e.g., a liability is collateralized by an asset measured at amortized cost or is contractually required to be settled upon the
derecognition of such an asset), (2) the financial liability is issued by and recorded in or evaluated by the chief operating decision maker as part of an
operating segment that subsequently measures less than 50 percent of the segment’s recognized assets at fair value, or (3) the financial liability does
not meet the above criteria but is a liability of a consolidated entity for which less than 50 percent of consolidated recognized assets are subsequently
measured at fair value.
22
Cash flow characteristics include (1) an amount (principal amount of the contract, adjusted by any original issue discount or premium) is transferred
to the debtor (issuer) at inception that will be returned to the creditor (investor) at maturity or other settlement; (2) the contractual terms of the debt
instrument identify any additional contractual cash flows to be paid to the investor, either periodically or at the end of the instrument’s term; and
(c) the debt instrument cannot contractually be prepaid or otherwise settled in such a way that the investor would not recover substantially all of its
initially recorded investment other than through its own choice.
23
Section 1: Significant Accounting Developments
25
Loan Commitments and Standby Letters of Credit
An entity that provides a loan commitment or financial standby letter of credit (“commitment”) must
classify such a commitment in the same way it classifies the loan that would be extended under the
outstanding offer. Thus, the commitment would be classified as FV-OCI if the resulting loan would be
classified as FV-OCI and as FV-NI if the loan would be classified as FV-NI. Loan commitments and financial
standby letters of credit held by a potential borrower are outside the scope of the proposed ASU.
Special Guidance for Broker-Dealers and Investment Companies
Under the proposed ASU, broker-dealers and investment companies must classify all of their financial
assets as FV-NI. Broker-dealers are permitted to use the FV-OCI or amortized cost categories for their
financial liabilities if those liabilities meet the qualifying criteria. However, investment companies must
classify all of their financial liabilities at fair value and recognize all changes in fair value as increases (or
decreases) in net assets for the period.
Measurement of Financial Instruments
The reporting basis of financial instruments that do not meet the amortized cost requirements will be
classified as fair value.
Initial Measurement
A financial instrument classified as FV-NI would be initially measured at fair value with any difference
between the actual transaction price and the estimated fair value immediately recognized as a gain or loss
in net income. Other financial instruments within the scope of the proposed ASU are initially measured at
their transaction price.
In addition, for financial instruments classified as FV-OCI, any difference between the transaction price
and fair value upon the first remeasurement is recognized in OCI. However, if on the basis of “reliable
evidence” an entity determines that there is a “significant” difference between the transaction price and
fair value at initial recognition for such an instrument, the entity would initially measure the financial
instrument at fair value.24
Transaction Costs and Fees
For a financial instrument classified as FV-NI, any initial transaction costs and fees (e.g., loan origination
fees and costs) are recognized in net income immediately as incurred. However, for those financial
instruments classified as FV-OCI, such charges are deferred and recognized in earnings as a yield
adjustment via the interest method over the life of the instrument (in a manner generally consistent with
current U.S. GAAP).
Further, preparers must consider additional income statement presentation issues that may arise. Notably,
investment companies that currently report transaction costs in net income as “realized and unrealized
gains or losses on financial instruments” will have geographical shifts in these costs because they would
become more akin to “investment income and expenses.”
The proposed ASU requires that if “reliable evidence” suggests a “significant difference” between the transaction price and fair value at initial
recognition, the entity must consider whether the transaction includes “other elements” (e.g., unstated rights and privileges) that would require
accounting under other U.S. GAAP.
24
Section 1: Significant Accounting Developments
26
Ongoing Fair Value Measurement
The changes proposed would significantly expand the use of fair value measurements in the financial
statements. Financial instruments that may currently be reported at amortized cost (e.g., held-to-maturity
securities, loans held for investment, and certain financial liabilities) would instead be measured at fair
value in the statement of financial position. Fair value accounting would also apply to nonmarketable
equity securities that are currently subject to the cost method of accounting and some that are currently
subject to the equity method of accounting (see additional discussion in the Equity Method of Accounting
section below).
A significant number of financial liabilities would also be measured at fair value instead of at amortized
cost. This has caused many to question whether these changes would indeed provide new meaningful
information to users of the financial statements because of the effect of the issuer’s own credit on these
measurements.
Other Measurement Attributes
Core Deposits
The proposal also potentially adds financial reporting complexity by introducing a new remeasurement
approach for core deposit liabilities. This new measurement basis would be considered neither fair value
nor amortized cost and, as a result, some contend that it is unclear what that new measurement attribute
is intended to represent. The proposed ASU indicates that entities would measure core deposit liabilities,25
if due on demand, at the present value of the average core deposit amount by using an implied maturity
of the deposits as the valuation time horizon. Entities would apply the measurement approach separately
for each major type of deposit by using a discount rate equal to the difference between the alternative
funds rate and the all-in-cost-to-service (the customer deposits) rate.
As a result, the core deposit liability on an entity’s balance sheet would be expected to be less than
the face amount of those same deposits, given that they are an inexpensive source of bank capital. In
addition, under the proposed ASU’s presentation changes, an entity would be required to display both the
amortized cost and the “fair value” of the core deposit liability in its balance sheet.
In proposing a remeasurement attribute for core demand deposit liabilities, the FASB appears to have
placed particular importance on (1) the fact that core deposits are a key source of value for a financial
institution and (2) its belief that a remeasurement attribute would give investors useful information about
assessing asset-liability mismatches.
Investments Redeemable at a Specified Amount
A financial instrument with all of the following characteristics would be exempt from the proposed fair
value measurement guidance:
a. [The financial instrument] has no readily determinable fair value because ownership is
restricted and it lacks a market.
b. It cannot be redeemed for an amount greater than the entity’s initial investment.
c. It is not held for capital appreciation but rather to obtain other benefits, such as access to
liquidity or assistance with operations.
Core deposits are defined in the ASU as “[d]eposits without a contractual maturity that management considers to be a stable source of funds, which
excludes transient and surge balances.”
25
Section 1: Significant Accounting Developments
27
d. It must be held for the holder to engage in transactions or participate in activities with the
issuing entity.
An entity must measure such an investment at its redemption value rather than at fair value. Although
the proposed guidance provides details necessary for an instrument to qualify for measurement at the
redemption value, this option conflicts with the primary objective of the proposed ASU, which is to
reduce complexity in the accounting for financial instruments (e.g., by limiting the number of different
measurement attributes). Specifically, measurement of the value of Federal Home Loan Bank stock or an
investment in the Federal Reserve Bank, which can be redeemed only for a specified amount, would not
be consistent with the measurement of other investments with similar risk profiles.
Interest Income Recognition
The proposed ASU includes guidance on how entities should recognize interest income for financial assets
that are classified as FV-OCI. Financial statement preparers calculate interest income by applying the
financial asset’s EIR to its amortized cost (net of any related allowance for credit impairments).
Determining the EIR is not always straightforward and largely depends on whether an asset was
purchased at a discount related, at least in part, to its credit quality. Specifically, financial assets purchased
at a discount that is not related to credit quality would have an EIR that equates the contractual cash
flows with the initial cash outflow (exclusive of any net deferred loan fees or costs, premium, or discount).
Alternatively, if an asset’s discount relates partially or wholly to credit quality, the EIR is set to a rate
that equates the entity’s estimate of cash flows expected to be collected with the purchase price of the
financial asset.
The approach for recognizing interest income on the basis of an asset’s amortized cost balance, net of
any allowance for credit losses, will often result in a difference between the amount of interest income
accrued and the amount of interest income contractually due, since the amount contractually due does
not take the allowance into account.
Financial Statement Presentation
Statement of Financial Position
Financial instruments classified as FV-NI and FV-OCI are presented separately on the face of the balance
sheet. Those classified as FV-OCI must include the following amounts in separate line items on the face of
the statement of financial position:
1. Amortized cost
2. Allowance for credit losses [on financial assets]
3. [Accumulated a]mount needed to adjust amortized cost less allowance for credit losses to fair
value
4. Fair value.
An entity is also required to present separately, on the face of the statement of financial position, either
(1) the amounts included in accumulated OCI that relate to changes in fair value or (2) the remeasurement
amount that has been recognized in OCI.
Section 1: Significant Accounting Developments
28
Income Recognition
For a financial instrument classified as FV-NI, all changes in fair value during the period are recognized
in net income. However, for those financial instruments classified as FV-OCI, a portion of the change in
fair value during the period is recognized in OCI.26 In addition, changes in fair value that were previously
recognized in OCI are recognized in net income when they are realized through sale or settlement.
Comprehensive Income
In conjunction with its proposed changes to the accounting for financial instruments, the FASB has
proposed a single statement of comprehensive income as part of the basic financial statements in each
reporting period.27 This single statement would include a total for comprehensive income and a subtotal
for net income. For financial instruments classified as FV-NI, an entity must present one aggregate amount
for realized and unrealized gains and losses on the face of the statement of comprehensive income.
For financial instruments classified as FV-OCI, an entity must present the following amounts recognized in
net income separately on the face of the statement of comprehensive income:
•
Current-period interest income and expense, including amortization (or accretion) of any
premium (or discount) at inception.
•
Credit impairment for the period.
•
Realized gains or losses (by means of an offsetting entry to OCI to the extent that prior-period
unrealized gains or losses on the instrument were reported in OCI).
For financial liabilities measured at fair value, an entity must separately present, on the face of the
statement of comprehensive income, significant changes in fair value that are related to an entity’s own
credit standing.
Credit Impairment
In a move to simplify the various impairment models currently spread throughout U.S. GAAP, the FASB is
proposing the use of the same credit impairment approach for most financial assets, such as loan assets,
debt securities, beneficial interests in securitized financial assets, and purchased loan assets with evidence
of credit deterioration. For instance, the proposed ASU’s impairment guidance would replace the current
U.S. GAAP approach to assessing OTTIs for debt securities.
Assessment and Measurement
Under the proposed ASU, an entity would recognize credit impairment when the entity “does not expect
to collect all contractual amounts due for originated financial asset(s) and all amounts originally expected
to be collected upon acquisition for purchased financial asset(s).” Note that the proposal does not allow
an entity to apply a probability threshold (e.g., similar to a loss contingency model) when assessing
whether a credit impairment has occurred. Although in assessing credit impairment, the entity would not
forecast future events or economic conditions that do not exist as of the reporting date, this proposed
approach requires an entity to consider the impact of past events and existing conditions on the current
and future collectability of the financial asset cash flows. The portion of change in fair value recognized in OCI equals the total change in fair value minus (1) current-period interest accruals (including
amortization or accretion of any premium or discount and certain deferred loan-origination fees and costs), (2) current-period credit losses (or
reversals), and (3) changes in fair value attributable to the hedged risk in a qualifying fair value hedge that are recognized in net income.
26
For further details, see Deloitte’s May 28, 2010, Heads Up.
27
Section 1: Significant Accounting Developments
29
After determining that credit impairment exists, an entity must:
[R]ecognize . . . at the end of each financial reporting period the amount of credit impairment related
to all contractual amounts due for originated financial asset(s) that the entity does not expect to collect
and all amounts originally expected to be collected for purchased financial asset(s) that the entity does
not expect to collect.
Unlike existing U.S. GAAP, the proposed ASU requires entities to use an allowance account to record credit
losses for investments in debt securities classified as FV-OCI, not just for loan assets. In addition, unlike
existing U.S. GAAP, the proposed ASU permits entities to evaluate not only loans but also investments in
debt securities for credit impairment on a collective, pool, or portfolio basis.
For example, a loan asset is originated with a principal amount of $100. At the end of the first reporting
period, credit impairment has occurred and the entity no longer expects to collect $12 of future principal
cash flows, which has a present value of $10. As a result, the entity records the following journal entry:
Debit
Credit loss
Allowance for credit loss (presented as a contra-asset)
$
Credit
10
$
10
Collective Basis
Unlike existing U.S. GAAP, the proposed ASU permits entities to measure impairment for investments in
debt securities classified as FV-OCI on a pooled or collective basis. Measuring impairments on a pooled
basis requires an entity to aggregate financial assets that share common risk characteristics (e.g., collateral
type, interest rate, and term). Subsequently, the entity applies a “loss rate” by using historical loss rates
that apply to the relevant pool of similar financial assets, adjusted for information about cash flow
collectability. The proposed ASU does not prescribe a specific method for determining historical loss rates.
Rather, it states that this method “may vary depending on the size of the entity, the range of the entity’s
activities, the nature of the entity’s pools of financial assets, and other factors.”
In some circumstances, a financial asset may have been individually evaluated for impairment, but
no past events or existing conditions indicate that an impairment exists. However, an entity must still
assess whether, for a group of similar financial assets (i.e., assets with similar risk characteristics), a loss
would have existed if the financial asset were assessed as part of a pool. If that is the case, the entity
must recognize a credit impairment for the financial asset measured by applying the historical loss rate
applicable to the group of similar financial assets referenced by the entity in its assessment.
Direct Write-Off of Financial Assets
An entity is required to write off a financial asset (or part of a financial asset) if and when the entity has
“no reasonable expectation of recovery” (i.e., the asset is uncollectible). The write-off is accomplished by a
reduction of the allowance for credit losses (i.e., Dr. Allowance, Cr. Financial asset). If cash is subsequently
received on a financial asset that was previously written off, this recovery is recognized in net income (i.e.,
Dr. Cash, Cr. Recovery).
Hedging Activities
The FASB also proposed significant changes to the hedge accounting requirements currently in U.S.
GAAP. Many individuals may have déjà vu when they read through these proposed changes because
the FASB proposed similar changes to the hedging requirements in 2008. After much debate of the
original proposal and the ongoing credit crisis, the FASB delayed its hedge accounting project until this
comprehensive financial instrument proposal was unveiled. The current proposal is similar to the 2008
Section 1: Significant Accounting Developments
30
proposal; however, the current proposal retains the existing ASC 815 provisions that allow an entity to
designate hedging relationships by risk (i.e., benchmark interest rate risk, foreign currency exchange rate
risk, and credit risk) for financial hedged items. The following discussion covers the highlights of the
current proposal.
Effectiveness Assessment
The proposed ASU lowers the minimum threshold to qualify for hedge accounting from “highly effective”
to “reasonably effective.” The FASB believes the lower threshold would reduce some of the complexities
preparers face in complying with the current hedge effectiveness requirements. Although the FASB did
not define the term “reasonably effective,” the proposed ASU states that preparers should use judgment
in determining whether the hedging relationship is reasonably effective. One of the consequences of the
FASB’s lowering of the minimum threshold to qualify for hedge accounting and simplification of the hedge
accounting model is the elimination of both the shortcut and critical terms match methods of hedge
accounting.
The FASB’s proposal also eliminates the need for an entity to periodically assess hedge effectiveness
quantitatively. Instead, for most hedging relationships, a qualitative assessment demonstrating that an
economic relationship exists between the hedging instrument and the hedged item is sufficient to show
that the hedging instrument will be reasonably effective at achieving offset. Sometimes, however, when
a qualitative assessment is inconclusive, an entity must supplement the qualitative assessment with a
quantitative analysis. After hedge inception, assessment of hedge effectiveness would not be necessary
unless changes in circumstances indicate that the hedging relationship may no longer be reasonably
effective.
Measuring and Reporting Ineffectiveness in Cash Flow Hedges
The proposal requires an entity to measure cash flow hedge ineffectiveness by comparing the change
in fair value of the actual hedging instrument with the present value of the cumulative change in
expected future cash flows of the hedged transaction. Unlike existing U.S. GAAP, the proposed ASU
would also require entities to record ineffectiveness for under-hedges in earnings. An entity may perform
its measurement calculations by using a hypothetical derivative to measure the cumulative change in
expected future cash flows of the hedged transaction. That hypothetical derivative would (1) be priced at
market, (2) mature on the date of the hedged transaction, and (3) exactly offset the hedged cash flows.
Dedesignations
Unlike existing U.S. GAAP, the proposed ASU prohibits an entity from electively removing a hedge
designation. A hedging relationship can be discontinued only if (1) it no longer meets one of the required
hedging criteria in ASC 815 or (2) the hedging instrument expires or is sold, terminated, or exercised.
An alternative to this prohibition would be for an entity to enter into an offsetting hedging position
and concurrently document that the offsetting hedging position has effectively terminated the original
hedge designation. The proposal does prohibit the redesignation of a previously dedesignated hedging
instrument.
Embedded Derivatives
The proposed ASU eliminates the current bifurcation requirements for financial host contracts that are
within its scope. Instead, such instruments must be classified as FV-NI and measured in their entirety at fair
value, with changes in fair value immediately recognized in earnings. The proposed ASU does not change
the bifurcation requirements for nonfinancial host contracts or for financial host contracts that are outside
its scope.
Section 1: Significant Accounting Developments
31
Equity Method of Accounting
The proposed ASU narrows the scope of equity method accounting under ASC 323 by requiring its
application to equity investments in which (1) the entity has significant influence over the investee and (2)
operations of the investee are considered related to the investor’s consolidated operations. The proposed
ASU lists qualitative factors that an investor should consider in determining whether the investee’s
operations are related to the investor’s consolidated operations (e.g., similar operations and common
employees). The proposed ASU also eliminates the fair value option for equity investments in ASC
825-10. Under the proposed ASU, any equity investment not accounted for under the equity method of
accounting is accounted for at fair value, with changes in fair value reported in net income.
Comment Letters
Since the ASU’s comment period closed on September 30, 2010, the FASB (and the general public) now
have significant insight into the observations, opinions, and recommendations of market participants.
Throughout the open comment period, the FASB received more than 2,600 responses from preparers,
auditors, and users.
As it expected might occur, the FASB received a sizable number of comments related to balance sheet
classification and fair value measurement (including impairment considerations). In general, respondents
largely supported the proposed changes for hedge accounting; specifically, they supported the lower
“reasonably effective” threshold and qualitative assessment for hedge effectiveness. Some preparers
and auditors that had reservations about the proposed dedesignation requirements noted the operating
challenges involved with maintaining a large day-to-day hedging portfolio.
In their commentary addressing classification and measurement, many preparers and auditors
recommended a mixed attribute measurement model, based on an entity’s business strategy, in which an
entity would (1) record assets held for collection or payment at amortized cost and (2) record assets held
for trading at fair value through current period earnings. Many respondents expressed reservations about
fair value measurement, noting that this measurement attribute potentially lacks reliability, especially for
illiquid instruments, and consequently increases the potential for earnings volatility.
The sentiments about classification and measurement were echoed in some of the investor comment
letters, which trended toward a belief that amortized cost is the most relevant measure for both loans
and an entity’s own debt that the entity intends to hold for collection or payment of cash flows. Although
amortized cost does not necessarily provide investors with sufficient data to generate price targets and
recommendations, many in the investor community proposed expanded risk disclosures, including interest
rate sensitivity and credit risk effect, for loans and own debt instruments.
From an impairment perspective, most comment letters, irrespective of industry, support the elimination of
the “probable” threshold to allow for more timely recognition of losses. Furthermore, some believe that a
lower threshold such as “more likely than not” is necessary. Some preparers and auditors disagreed with
recognizing the entire expected loss up front and suggested allocating the allowance over the life of the
instrument.
Potential Effective Date and Transition
The FASB deferred proposing an effective date for the ASU until it considers the comments received. Early
adoption would be prohibited. An entity will transition to the new standard by recording a cumulativeeffect adjustment in the statement of financial position for the reporting period that immediately precedes
the effective date. For example, if the proposed ASU were to be effective for fiscal years beginning after
Section 1: Significant Accounting Developments
32
December 15, 2013, a calendar-year entity would be required to restate its statement of financial position
as of December 31, 2013, in its financial report for the first quarter of 2014.
For nonpublic entities with less than $1 billion in total consolidated assets, certain provisions of the
proposed ASU would have a deferred effective date for four years after the original effective date of the
final standard.
Table 1 — Financial Instrument Classification
The proposed ASU makes sweeping changes to the recording and measurement attributes of financial
assets and liabilities. The following table summarizes these changes.
Topic
FASB’s Proposed ASU
Categories of
financial assets and
financial liabilities
Effectively, six categories of financial assets and financial liabilities:
• FV-NI (default category).
• FV-OCI (elective for qualifying debt instruments).
• Amortized cost (elective for qualifying liabilities and short-term payables and receivables).
• Redemption value (required for certain redeemable investments).
• Remeasurement approach for core deposits through net income (default category for core
demand deposit liabilities).
• Remeasurement approach for core deposits through OCI (elective for qualifying core
demand deposit liabilities).
Criteria for amortized
cost measurement
An entity can elect to carry the following financial instruments at amortized cost:
• Short-term receivables and payables (other than short-term lending arrangements, such
as credit card receivables) arising in the normal course of business, and due in customary
terms not exceeding one year, that meet the criteria for classification as FV-OCI (see
below).
• Financial liabilities that meet the criteria for classification as FV-OCI (see below), provided
that measuring the financial liability at fair value would create or exacerbate an accounting
mismatch.
Criteria for FV-OCI
classification
An entity can classify a financial asset or financial liability as FV-OCI if it meets all of the following
criteria:
• Cash flow characteristics — A debt instrument that cannot contractually be prepaid or
otherwise settled in such a way that the investor would not recover substantially all of its
initially recorded investment, other than through its own choice.
• Business strategy — Business strategy for the instrument is to collect or pay the related
contractual cash flows.
• No embedded derivative required to be separated — It is not a hybrid instrument for which
an embedded derivative is required to be separated under existing U.S. GAAP.
For instruments in this category, current-period interest accruals, credit losses, and realized gains or
losses are recognized in earnings.
Reclassification of
accumulated OCI to
net income
Amounts in accumulated OCI are recycled to net income upon sale, settlement, or impairment.
Equity investments
Carried at fair value, with changes in fair value recognized in earnings, except for certain redeemable
investments that are carried at redemption value, with changes in the redemption value recognized
in earnings.
Section 1: Significant Accounting Developments
33
Topic
FASB’s Proposed ASU
Embedded
derivatives in hybrid
financial contracts
Hybrid financial contracts with an embedded derivative, which currently must be bifurcated under
ASC 815, would instead be measured in their entirety at fair value, with changes in fair value
recognized in earnings. No embedded derivative would be bifurcated from a hybrid financial asset or
liability (except for hybrid financial instruments that are outside the proposed ASU’s scope).
An entity is permitted to classify as FV-OCI hybrid financial contracts that meet the FV-OCI
classification criteria and that contain an embedded derivative that does not require bifurcation under
ASC 815.
Fair value option
No explicit fair value option.
Reclassification
Not permitted.
Table 2 — Comparison of Proposals Under U.S. GAAP and IFRSs
The FASB’s proposed ASU was written as part of the boards’ broader convergence project; however,
convergence is incomplete. This table summarizes, by topical area, the differences between proposals
related to financial instruments under U.S. GAAP and IFRSs.
Topic
FASB’s Proposed ASU
Proposed IFRSs28
Classification and
measurement
Two measurement bases for most financial
instruments: FV-NI and FV-OCI.
Three measurement bases for financial
instruments: FV-NI, FV-OCI, and amortized cost.
Amortized cost available for financial liabilities
with an accounting mismatch.
Amortized cost required for certain debt
instruments.
No reclassification.
Reclassification required in certain cases;
expected to be uncommon.
Remeasurement value.
No special guidance for demand deposit
liabilities.
Core deposits
Measure at amounts payable on demand.
Impairment
Only instruments with changes through OCI are
tested for impairment.
Only instruments measured at amortized cost are
tested for impairment.
Single impairment model.
Single impairment model.
Embedded
derivatives
No separation.
No bifurcation for financial assets. Bifurcation for
financial liabilities still possible.
Hedge accounting
Qualitative effectiveness, bifurcation by risk for
hedged financial items.
Same classification approach as for hybrids with
financial hosts.
Simplified effectiveness guidance, bifurcation by
risk for both financial and nonfinancial items.
Financial Reporting Implications of the Dodd-Frank Wall Street Reform
and Consumer Protection Act
On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection
Act (the “Dodd-Frank Act”) into law. The Dodd-Frank Act is arguably the most sweeping change to
financial regulation in the United States since the changes that followed the Great Depression and was
created in response to widespread calls for change in the financial regulatory system as a result of the
near collapse of the world’s financial system in the fall of 2008 and the ensuing global credit crises, which
some have termed the “Great Recession.”
IASB proposals related to financial assets, fair value option on liabilities, impairment, and the IASB’s tentative decisions related to hedge accounting.
28
Section 1: Significant Accounting Developments
34
The Dodd-Frank Act is intended to:
•
Promote U.S. financial stability by “improving accountability and transparency in the financial
system.”
•
Put an end to the notion of “too big to fail.”
•
“[P]rotect the American taxpayer by ending bailouts.”
•
“[P]rotect consumers from abusive financial services practices.”
To achieve these broad objectives, Congress included in the legislation many provisions whose magnitude
will not be fully appreciated until regulators have implemented them by adopting new rules and
regulations. This section summarizes certain aspects of the Dodd-Frank Act that may have financial
reporting implications for the financial services industry.
Permanent Exemption From Section 404(b) of the Sarbanes-Oxley Act of 2002 for
Smaller Public Entities That Are Nonaccelerated Filers
The Dodd-Frank Act provides for a permanent exemption for nonaccelerated filers (i.e., public entities
whose public float is less than $75 million)29 from the requirement to obtain an external audit on the
effectiveness of internal control over financial reporting under Section 404(b) of the Sarbanes-Oxley Act of
2002 (the “Sarbanes-Oxley Act”). The Dodd-Frank Act negates SEC Rule 33-9072, issued in October 2009,
which would have required all nonaccelerated filers to comply with Section 404(b) starting in their annual
reports for fiscal years ending on or after June 15, 2010. In testimony to the House Financial Services
Subcommittee, SEC Chairman Mary Schapiro stated that for the brief period between when this provision
of the Dodd-Frank Act would be effective and when the requirement to comply with Section 404(b) under
the SEC’s October 2009 final rule became effective, a nonaccelerated filer would not have to comply with
the SEC rule. On September 15, 2010, the SEC issued Rule 33-9142, which conforms to the exemption
from Section 404(b) included in the Dodd-Frank Act.
Establishment of PCAOB Authority Over Auditors of Broker-Dealers
Under the Sarbanes-Oxley Act, auditors of nonpublic broker-dealers that are registered with the SEC
currently must be registered with the PCAOB; however, they have not otherwise been subject to PCAOB
oversight. Under the Dodd-Frank Act, auditors of nonpublic broker-dealers are now subject to PCAOB
oversight, including its rulemaking power to require an inspection program for such auditors and the
ability to set standards for their audits.
The legislation also requires broker-dealers to pay an annual accounting support fee to the PCAOB to
support the Board’s activities. This fee must be “in proportion to the net capital of the broker or dealer . . .
compared to the total net capital of all brokers and dealers.” The PCAOB is expected to issue for public
comment proposed rules on the assessment and collection of these fees.
Enhancements to the Asset-Backed Securitization Process
To solve problems in the securitization markets identified during the credit crisis and to better align the
incentives of the participants in these markets, the Dodd-Frank Act requires that securitizers30 of financial
assets “retain an economic interest in a portion of the credit risk” of the assets through investments in the
securities that the assets back.31 The legislation stipulates that securitizers must retain at least 5 percent
of the credit risk of securitized assets (unless certain underwriting standards indicate low credit risk, in
which case the threshold will be less than 5 percent). In addition, it explicitly prohibits securitizers from
The Dodd-Frank Act exempts issuers that are neither “large accelerated filers” nor “accelerated filers,” as these terms are defined in Rule 12b-2 of the
Securities Exchange Act of 1934, so the exemption also would extend to debt-only issuers.
29
The Dodd-Frank Act defines a “securitizer” as “an issuer of an asset-backed security” or “a person who organizes and initiates an asset-backed
securities transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuer.”
30
The Dodd-Frank Act defines an “asset-backed security” as “a fixed-income or other security collateralized by any type of self-liquidating financial asset
(including a loan, a lease, a mortgage, or a secured or unsecured receivable) that allows the holder of the security to receive payments that depend
primarily on cash flow from the asset, including — (i) a collateralized mortgage obligation; (ii) a [CDO]; (iii) a collateralized bond obligation; (iv) a
[CDO] of asset-backed securities; (v) a [CDO] of [CDO]s; and (vi) a security that the [SEC], by rule, determines to be an asset-backed security.”
31
Section 1: Significant Accounting Developments
35
hedging or transferring the required retained credit risk and exempts securitizers of qualified residential
mortgages32 from the requirement to retain a portion of the credit risk of the underlying assets. Moreover,
the Dodd-Frank Act directs the SEC to establish rules that would require securitizers to disclose (1) “for
each tranche or class of security, information regarding the assets backing that security” and (2) “fulfilled
and unfulfilled repurchase requests across all trusts aggregated by the securitizer.” In October 2010,
in response to the legislation, the SEC issued proposed rules33 under which securitizers would disclose
information about due diligence that either they or third parties performed on the underlying assets as
well as fulfilled and unfulfilled repurchase requests across all securitization transactions. Comments on the
proposed rules were due by November 15, 2010.
Note that in April 2010, the SEC proposed amendments34 to the reporting requirements and offering and
disclosure process for ABS. Like the Dodd-Frank Act, the amendments propose a 5 percent minimum
threshold for the amount of credit risk that a securitizer must retain in a securitization of financial assets.
However, under the SEC’s amendments, the minimum threshold would be a vertical slice (i.e., the
securitizer would be required to hold a proportional (minimum) 5 percent interest in the securitization
vehicle, which amounts to 5 percent of each tranche issued by the vehicle). The Dodd-Frank Act does not
address this issue. Irrespective of whether the 5 percent interest would be proportional or subordinated,
entities that use securitizations to fund their operations and (1) did not retain an interest in a vehicle to
which they transferred assets or (2) retained an interest of less than 5 percent will need to consider how
the interest that the legislation would require them to hold affects any consolidation and derecognition
analyses.
On the basis of a survey of the comment letters submitted to the SEC on the proposed amendments, the
financial services industry’s views on risk retention can be summarized as follows:
•
Generally, both issuers and investors are in favor of a risk-retention proposal acknowledging the
need to align the economic interests of originators and sponsors with those of investors. Both
groups are split, however, on how the risk-retention requirements should be applied. It was
noted that the majority of those commenting expressed preference for flexibility in the ways in
which issuers can retain risk (i.e., vertical slice, horizontal slice, retention of randomly selected
exposures, availability of exceptions, and variations to calibrate risk retention with asset quality)
and a strong opposition to a one-size-fits-all retention requirement.
•
Most respondents expressed concern regarding the impact of the risk-retention requirement on
the accounting consolidation analysis for a securitization. The 5 percent risk retention may not,
in and of itself, trigger consolidation of the securitized vehicle but, coupled with other factors
such as other recourse requirements or servicing arrangements, may be significant enough to
trigger consolidation. Respondents called for coordination among the regulators, accounting
community, and other professionals to avoid unintended consequences related to the securitizers’
ability to obtain derecognition.
•
Many respondents called for regulatory harmonization given that the risk-retention
requirements have been contemplated in the proposed FDIC securitization rule (“safe harbor”
rule) amendment, the SEC proposed rule on ABS, the European Union capital requirements
directive amendments, and the Dodd-Frank Act. Respondents made similar comments on the
accompanying disclosure standards proposed by the SEC and the FDIC and those under the
Dodd-Frank Act, which are inconsistent.
The Dodd-Frank Act does not define “qualified residential mortgages”; rather, it directs the SEC and other federal agencies to jointly establish a
definition.
32
SEC Proposed Rules 33-9150 and 33-9148.
33
SEC Proposed Rule 33-9117.
34
Section 1: Significant Accounting Developments
36
Greater Oversight of Credit Rating Agencies
The Dodd-Frank Act imposes significant structural, regulatory, and liability reforms on credit rating
agencies. Most noteworthy for registrants that issue ABS is the elimination of the exemption for credit
ratings provided by NRSROs from being considered a part of a “registration statement” or certified by a
“person,” as those terms are used in Sections 7 and 11 of the Securities Act of 1933 (the “Securities Act”).
Accordingly, to include an NRSRO credit rating in a registration statement, SEC registrants must obtain a
consent from the NRSRO and file it along with the registration statement. NRSROs would thus be treated
as “experts” under Section 11 of the Securities Act and would be liable for material misstatements or
omissions associated with these included ratings.
On July 27, 2010, the SEC’s Division of Corporation Finance issued new C&DIs on the use of credit
ratings for issuers not subject to Regulation AB. The new C&DIs provide interpretive guidance on when a
registrant would be required to name a credit agency as an expert and obtain its consent in conjunction
with the use of credit rating information in a registration statement. For example, the C&DIs point out that
“some issuers note their ratings in the context of a risk factor discussion regarding the risk of failure to
maintain a certain rating and the potential impact a change in credit rating would have on the registrant.”
In that case and in disclosing other “issuer disclosure-related ratings information” (e.g., changes to a
credit rating, the liquidity of the registrant, the cost of funds for a registrant, or the terms of agreements
that refer to credit ratings), the registrant would not be required to obtain a consent from the credit rating
agency.
Executive Compensation and Corporate Governance
The Dodd-Frank Act includes a variety of executive compensation and corporate governance provisions.
For example, it requires public companies to allow shareholders a nonbinding vote on the compensation
of named executive officers (NEOs) at least once every three years (“say on pay”). In addition,
public-company shareholders must be allowed a nonbinding vote to approve any “agreements or
understandings” that the entity has with its NEOs regarding any type of compensation paid in connection
with “an acquisition, merger, consolidation, or proposed sale or other disposition of all or substantially
all the assets of an issuer,” unless such agreements or understandings have been subject to a shareholder
vote under the general say-on-pay provisions (“say on golden parachutes”).
In another significant provision of the legislation, the SEC is required to establish rules requiring that
entities, in the event of an accounting restatement attributable to material noncompliance with financial
reporting requirements, develop policies mandating the recovery (or “clawback”) of “excess” incentive
compensation paid to executive officers under incentive plans. Such recovery of incentive compensation
would be required regardless of whether the executive officer was involved in the misconduct that led to
the restatement.
Entities should consider (1) whether the clawback rules, once issued by the SEC, would call into question
whether the entity has established a grant date35 in accordance with ASC 718 and (2) the potential
accounting implications if a grant date has not been established. The accounting for these expanded
provisions in share-based payment awards is highly dependent on the facts and circumstances. If
the terms of the provision are broad, subjective, and discretionary, an entity may be precluded from
establishing a grant date for the award in accordance with ASC 718, since the nature of the provision may
prevent the employee from reaching a mutual understanding about the key terms and conditions of the
share-based payment award. If the terms of the provision are clear and measurable, do not allow for the
entity’s exercise of discretion, and are communicated to the employees, an entity may be able to establish
a grant date.
See definition of grant date in ASC 718-10-20.
35
See ASC 718-10-55-108 for the criteria to establish a service inception date before the grant date.
36
Section 1: Significant Accounting Developments
37
If an entity determines that the terms of the award do not establish a grant date, the entity must consider
whether a service inception date exists in accordance with ASC 718.36 The service inception date is the
beginning of the requisite service period, which is normally the same as the grant date but may precede
the grant date if certain criteria are met. The service inception date is important because it is used to
determine when the recognition of compensation cost begins. If the service inception date criteria are not
met, an entity would not begin recognizing compensation cost until a grant date has been established. In
addition, to the extent that entities contemplate changing any of the terms or conditions of their existing
executive share-based payment plans (or awards) as a result of the Dodd-Frank Act, they should consider
the guidance on modification accounting in ASC 718.
Changes to the SIPC
The Dodd-Frank Act increases (1) the credit line at the U.S. Treasury from $1 billion to $2.5 billion and (2)
the minimum assessments paid by the SIPC members from $150 per year to two basis points of an SIPC
member’s gross revenues.37
The Volcker Rule
Named after Paul Volcker, chairman of the Economic Recovery Advisory Board under President Obama,
the Volcker Rule is intended to reduce the amount of speculative investments on large financial firms’
balance sheets and, with limited exception, prohibits any banking entity from engaging in proprietary
trading or sponsoring, or investing in, hedge funds or private equity funds. An entity should consider
whether the divestiture of its proprietary trading business would require it to (1) reclassify as available for
sale the associated securities that it has previously classified as held to maturity and carried at amortized
cost and (2) measure these securities at fair value and recognize the changes in fair value in OCI. Further,
to the extent that its proprietary trading business includes any underwater securities for which it has
accumulated unrealized losses in OCI, an entity should consider whether its intention, or the Act’s
requirement, to dispose of the securities causes it to realize these losses as an OTTI.
Regulation of OTC Derivatives
The Dodd-Frank Act requires entities to clear most OTC derivatives through regulated, central clearing
organizations and to trade the derivatives on regulated exchanges to increase transparency. With this new
requirement, entities will have to consider whether these market mechanisms provide a means of net
settlement, in which case the contracts that previously did not meet the definition of a derivative in ASC
815-10-15-83 would meet the definition of a derivative and must be measured at fair value, with changes
in fair value recognized in earnings (provided that they do not qualify for the normal purchases and sales
scope exception). In addition, banks using the “swaps pushout rule” and pushing their swaps business to
a bank affiliate should consider whether the pushout affects the makeup of the operating segments that
they currently disclose in the footnotes.
Regulation of Advisers to Hedge Funds and Private Equity Funds
The Dodd-Frank Act requires most managers of hedge funds and private equity funds to register with the
SEC as investment advisers and provide information about their trades and portfolios that is necessary to
the assessment of systemic risk.
Section 929V of the Dodd-Frank Act, “Increasing the Minimum Assessment Paid by SIPC Members,” which revises Section 4(d)(1)(C) of the Securities
Investor Protection Act of 1970 (15 U.S.C. 78ddd(d)(1)(C)).
37
Section 1: Significant Accounting Developments
38
Section 2
SEC Update and Hot Topics
Introduction
This section summarizes recent SEC rulemaking activities and legislation that could affect financial
reporting for various financial services companies. The discussion does not include recent rules related to
the proxy system and proxy disclosure enhancements. Instead, it focuses on activity that potentially could
directly affect the financial reporting process.
SEC Issues Various Proposed and Final Rules and Interpretations
Affecting Financial Reporting
SEC Issues Compliance and Disclosure Interpretations on Non-GAAP Measures
On January 11 and 15, 2010, the SEC’s Division of Corporation Finance issued new C&DIs on the use
of non-GAAP financial measures. The new guidance provides registrants with more flexibility to disclose
non-GAAP measures in filings with the SEC. The C&DIs replace the interpretative guidance in the SEC
staff’s “Frequently Asked Questions Regarding the Use of Non-GAAP Measures” (the “FAQs”), which
was issued in June 2003, but the rules on non-GAAP financial measures (Regulation G and Item 10(e) of
Regulation S-K) were not amended.
Many of the changes reflected in the C&DIs are the result of a recent SEC staff review of its interpretations
of non-GAAP measures. In December 2009, the SEC staff commented at the AICPA National Conference
on Current SEC and PCAOB Developments that the purpose of its review was to ensure that non-GAAP
guidance was not being read “in a fashion that causes companies to keep key information out of their
filings, which they are otherwise using to tell investors their story [through communications such as
earnings calls and press releases] and which they believe is the most meaningful indicator of how they are
doing.” While registrants frequently include non-GAAP financial measures in press releases, many have
been reluctant to include these same measures in filed documents because of restrictions in the now
rescinded FAQs.
Specifically, the C&DIs (1) revised the guidance on nonrecurring, infrequent, or unusual items in FAQs 8
and 9 and replaced it with C&DI 102.03 and (2) revised the guidance on the meaning of the concept
“expressly permitted” in FAQ 28 and replaced it with C&DI 106.01. In addition, C&DI 102.04 was added,
which clarifies that a registrant is not prohibited from “disclosing a non-GAAP financial measure that is not
used by management in managing its business.”
SEC Issues Final Rule Removing Requirement for Auditor Attestation Report on
Internal Control Over Financial Reporting in Annual Reports of Nonaccelerated
Filers
On September 15, 2010, the SEC finalized Rule 33-9142, which amends certain SEC rules and forms to
conform them to Section 404(c) of the Sarbanes-Oxley Act, as added by Section 989G of the Dodd-Frank
Act. The amendments became effective September 21, 2010.
The final rule states that under Section 404(c) of the Sarbanes-Oxley Act, Section 404(b) is not applicable
to “any audit report prepared for an issuer that is neither an accelerated filer nor a large accelerated filer
as defined in Rule 12b-2 under the Securities Exchange Act of 1934 (the “Exchange Act”).”
Section 2: SEC Update and Hot Topics
39
SEC Issues Proposed Rule and Interpretive Release to Enhance Short-Term
Borrowing Disclosures
On September 17, 2010, the SEC unanimously approved a proposed rule to address temporary declines
in short-term borrowings — usually around a period-end — commonly referred to as “window dressing.”
In part, the measures in the proposed rule result from (1) liquidity issues caused by certain transactions
involving repurchase agreements known as “Repo 105” transactions; (2) SEC inquiries earlier this year of
registrants to understand the types, extent of use, and accounting for repurchase agreements and other
similar transactions; and (3) the SEC’s conclusion that there was insufficient disclosure related to these
types of transactions and other similar arrangements.
The proposed rule would require registrants to disclose more information about their short-term
borrowing arrangements and therefore help investors better understand a registrant’s financings during
a period as well as at period-end. It expands the applicability of disclosure requirements related to shortterm borrowings from bank holding companies to all registrants and requires quarterly reporting of shortterm borrowings in addition to annual disclosures. Comments were due by November 29, 2010.
Quantitative Disclosures
The proposed rule requires registrants to provide the following quantitative disclosures in a tabular format
in the new subsection within the liquidity and capital resources discussion in MD&A:
•
The balance for each short-term borrowing category at period-end and the weighted-average
interest rate for those borrowings.
•
The average balance for each short-term borrowing category for the reporting period (including
the weighted-average interest rate).
•
The maximum balance for each short-term borrowing category for the period (daily maximum for
financial companies,1 month-end maximum for all other registrants).
Qualitative Disclosures
In addition to the quantitative disclosures, registrants are required under the proposed rule to disclose
qualitative information within MD&A, including:
•
A general description and the business purpose for the arrangements within each short-term
borrowing category.
•
The importance of short-term borrowing arrangements and how these arrangements affect
funding of a registrant’s operations and its risk-management activities (e.g., “liquidity, capital
resources, market-risk support, credit support or other benefits”).
•
The rationale or context for the maximum level reported for the period as well as significant
fluctuations between average short-term borrowings for the period and the balance at
period-end.
The proposed rule’s requirements would apply to quarterly and annual reports and registration
statements. For annual reports of financial companies (as defined in the proposed rule), three years
of annual disclosures and fourth-quarter disclosures would be required. For interim reporting under
the proposed rule, the same level of disclosure would be required as that for annual reporting. In
In a press release, the SEC noted that under the proposal, a financial company is an entity that is “[e]ngaged to a significant extent in the business of
lending, deposit-taking, insurance underwriting or providing investment advice [or is a] broker or dealer as defined in Section 3 of the Exchange Act.”
1
Section 2: SEC Update and Hot Topics
40
addition, registrants would be required to identify material changes. For quarterly reports, the proposal
requires short-term borrowings disclosure information only for the relevant quarter; it does not require
comparative data.
The SEC also issued a companion release that provides interpretive guidance intended to improve the
overall discussion of liquidity and capital resources in MD&A. The guidance in the interpretive release
became effective September 28, 2010.
SEC Issues Proposed Rules Addressing Securities and Capital Markets
SEC Issues Proposed Rules on Asset-Backed Securities
On April 7, 2010, the SEC issued for public comment a proposed rule on ABS that would significantly
revise Regulation AB (which governs ABS offerings) and other rules regarding the offering process,
disclosure, and reporting for ABS. According to Chairman Mary Schapiro, the proposed rules would
“fundamentally revise the regulatory regime for asset-backed securities.” Some of the provisions of the
proposed rule include:
•
Revisions to the “filing deadlines for ABS offerings to provide investors with more time” to make
investment decisions.
•
Elimination of “current credit ratings references in shelf eligibility criteria” and establishment of
new shelf eligibility criteria for ABS.
•
A “requirement that the sponsor retain a portion of each tranche of the securities that are sold.”
•
A “requirement that prospectuses for public offerings of [ABS] and ongoing [periodic] reports
contain specified asset-level information about each of the assets in the pool . . . in a tagged data
format using eXtensible Markup Language (XML),” with some limited exceptions.
•
“[N]ew information requirements for the safe harbors for exempt offerings and resales of [ABS].”
Specifically, the rule would no longer require that ABS offered publicly through shelf offerings be rated as
investment grade by NRSROs. Replacing this requirement is a series of proposed safeguards, including a
requirement for sponsors to retain a minimum of 5 percent of each tranche of securities that are sold on
an ongoing basis, net of hedging, and a requirement for the chief executive officer of the issuer to certify
that the securitized assets backing the securities being issued are likely to generate cash flows in amounts
consistent with what is described in the prospectus. See Section 1 for additional discussion of the riskretention requirements for this rule under the Dodd-Frank Act. Comments on the proposed rule were due
by August 2, 2010.
In October 2010, the SEC issued two rule proposals, Release 33-9148 and Release 33-9150, on offerings
of ABS under Sections 943 and 945 of the Dodd-Frank Act, respectively. In Release 33-9148, the
SEC proposes to (1) require entities that securitize ABS “to disclose fulfilled and unfulfilled repurchase
requests across all transactions” and (2) “require nationally recognized statistical rating organizations to
include information regarding the representations, warranties and enforcement mechanisms available
to investors” of ABS offerings when credit ratings accompany the offering. In Release 33-9150, the SEC
proposes to require (1) issuers of ABS “to perform a review of the assets underlying the ABS” and “to
disclose the nature of [their] review of the assets and the findings” and (2) issuers or underwriters of ABS
to “disclose the third-party’s findings and conclusions,” including certain disclosures about third-party
due diligence providers, when a third party is engaged to perform the review of underlying assets on the
issuer’s behalf. The comment period for both proposals ended on November 15, 2010.
Section 2: SEC Update and Hot Topics
41
SEC Issues Proposed Rule on Large Trader Reporting System
On April 14, 2010, the SEC issued for public comment a proposed rule that would establish a new large
trader reporting system. The proposal is intended to assist the SEC in obtaining information about traders
that engage in a substantial amount of trading activity to assess the impact of individual trader activity
on capital markets and to reconstruct activity in periods of unusual market volatility. According to an SEC
press release about the proposal, the term “large trader” is defined as a person whose transactions “equal
or exceed two million shares or $20 million during any calendar day, 20 million shares or $200 million
during any calendar month.” The proposal requires that large traders identify themselves and make certain
disclosures to the SEC, including among other things, information about the principal place of business,
nature of the business, identification of accounts, affiliate information, and whether the large trader or
affiliates are regulated entities. The proposed rule imposes requirements on registered broker-dealers that
would be required to maintain transaction records for each large trader and to report that information to
the SEC upon request. Comments on the proposed rule were due by June 22, 2010.
SEC Issues Proposed Rule on Access to Listed Options Exchanges
On April 14, 2010, the SEC issued for public comment a proposed rule that would (1) prohibit an
options exchange from unfairly impeding access to quotations it displays and (2) limit the fees an
options exchange can charge investors and others wishing to access a quote on an exchange. These two
measures would make the requirements for access to options markets comparable to those for existing
rules in stock markets. Comments on the proposed rule were due by June 21, 2010.
SEC Proposes Consolidated Audit Trail System to Better Track Market Trades
On May 26, 2010, the SEC issued a proposed rule that would require national securities exchanges and
national securities associations (“self-regulatory organizations” or SROs) to establish a consolidated audit
trail system. In announcing the proposed rule, Chairman Schapiro referred to the May 6 crash, which
saw an unprecedented one-time drop in major indexes in a relatively short period. In the aftermath, Ms.
Schapiro conceded that regulators’ efforts to “reconstruct the trading on that day are substantially more
challenging and time consuming than we would have liked because no standardized, automated system
exists to collect data across the various trading venues, products and market participants.” The goal of the
proposed rule is to address potential gaps in regulators’ abilities to detect illegal trading activity involving
multiple markets and products. Problems with the existing system include significant volumes resulting
from computerized trading and the lack of uniformity in, and cross-market compatibility of, current SRO
audit trails. Under the proposed rule, SROs would file jointly with the Commission, within 90 days of
approval of the proposed rule, a national market system (NMS) plan to create, implement, and maintain a
consolidated audit trail. In addition, SROs would be required to provide certain data to a central repository
within one to two years after the NMS plan becomes effective. Comments on the proposed rule were due
by August 9, 2010, and certain comment letters have highlighted concerns about confidentiality of the
information submitted and the potential risk of front-running trading patterns from institutional investors.
SEC Finalizes Rules Addressing Securities and Capital Markets
SEC Issues Final Rule on Amendment to Municipal Securities Disclosure
On May 27, 2010, the SEC issued Final Rule 34-62184A, which amends certain requirements regarding
the information to be made available for primary offerings of municipal securities. Under the current
regulatory framework, municipal securities are not subject to the disclosure requirements of federal
securities laws. Accordingly, this rule is intended to enhance information provided to investors by
regulating those that underwrite or sell municipal securities. In a press release announcing the unanimous
Section 2: SEC Update and Hot Topics
42
vote on the final rule, Chairman Schapiro hinted at further regulation down the road when she
commented, “Although I believe that the [SEC’s] regulatory authority over the municipal securities market
should be expanded in order to better protect investors and issuers alike, [these measures] represent an
important improvement within our present statutory authority.”
The final rule changes and expands Rule 15c2-12 of the Exchange Act as follows:
•
Increases scope of securities subject to the rule — The amendments remove the exemption
that existed; new issuances of variable rate demand obligations are now subject to the rule’s
provisions.
•
Changes requirements for disclosure of important events — The rule previously required an
underwriter to reasonably determine that the issuer or obligated person agreed to provide notice
of specified events. Because the amendments eliminate the materiality threshold for providing
notice to the Municipal Securities Rulemaking Board, disclosure of certain events will be required
as outlined in the rule, regardless of materiality. In addition, the list of events for which notice is
to be provided is expanded to include “(1) tender offers; (2) bankruptcy, insolvency, receivership
or similar proceeding . . . ; (3) the consummation of a merger, consolidation, or acquisition
involving . . . the sale of all or substantially all of the assets of the obligated person [or their
termination], if material; and (4) appointment of a successor or additional trustee, or the change
of name of a trustee, if material.”
•
Clarifies deadline for reporting on events — The revised rule requires that a broker, dealer, or
municipal securities dealer reasonably determine that the issuer or obligated person has agreed
to provide notice of specified events in a timely manner not in excess of 10 business days after
the event’s occurrence. Previously, the rule required notice of events listed in the rule to be made
“in a timely manner.”
The compliance date of the new rules was December 1, 2010.
SEC Extends Compliance Date for Amendments to Regulation SHO
The SEC extended for a limited period the compliance date for the amendments to Rule 201 and
Rule 200(g). Rule 201 requires exchanges to implement a short-sale-related circuit breaker that, when
triggered, would impose a restriction on the prices at which securities may be sold short. The amendments
to Rule 200(g) provide that a broker-dealer may mark certain qualifying short sale orders “short exempt.”
The Commission is extending the compliance date for these amendments to give certain exchanges and
industry participants additional time to modify their current procedures and provide time for programming
and compliance tests to determine adherence to the rules. As a result, the SEC changed the compliance
date for these amendments from November 20, 2010, to February 28, 2011.
Risk Management Controls for Brokers or Dealers with Market Access
The SEC finalized Rule 34-63241, which requires brokers or dealers with access to trading securities
directly on an exchange or alternative trading system “to establish, document, and maintain a system
of risk management controls and supervisory procedures that, among other things, are reasonably
designed to (1) systematically limit the financial exposure of the broker or dealer that could arise as a
result of market access, and (2) ensure compliance with all regulatory requirements that are applicable
in connection with market access.” These controls and procedures must also be reasonably designed to
prevent orders that appear erroneous or exceed certain preset credit or capital thresholds.
Section 2: SEC Update and Hot Topics
43
Furthermore, the rule requires a broker or dealer with market access to establish a system for monitoring
the effectiveness of its programs and controls and implement a process to address any issues promptly.
The broker or dealer must conduct a review no less frequently than annually to ensure the overall
effectiveness of its risk management controls, and the overall system of controls and annual review
process must be certified annually by the chief executive officer (or equivalent officer) of the broker or
dealer.
The rule will be effective 60 days from the date of its publication in the Federal Register, and once
effective, broker-dealers subject to the rule will have six months to comply with its requirements.
Recent Legislation
Financial Reporting and Disclosure Implications of the Health Care Reform
Legislation
On March 23, 2010, President Obama signed into law the Patient Protection and Affordable Care Act.
Seven days later, the president signed into law a reconciliation measure, the Health Care and Education
Reconciliation Act of 2010. The passage of the Patient Protection and Affordable Care Act and the
reconciliation measure (collectively, the “Act”) has resulted in comprehensive health care reform legislation.
The effects of the Act on the U.S. economy could be as sweeping as those resulting from the passage of
Medicare and Social Security.
Entities will need to identify and plan for changes related to accounting and disclosures that will result
from the Act. For example, public entities may need to add disclosures about the positive or negative
impact of the Act in their financial statements and MD&A in periodic reports (such as Forms 10-K and
10-Q filings) and registration statements. Registrants will also need to consider the Act’s effect and
potentially provide additional disclosure of any material trends and uncertainties that are known or
reasonably expected in accordance with Regulation S-K, Item 303.
In addition, although each public entity will need to analyze the Act on the basis of its own facts
and circumstances to determine what, if any, disclosure should be made in its securities filing, certain
provisions of the Act that are more likely to warrant disclosure considerations for an entity that is not
operating in a health-care-related industry include the following:
Section 2: SEC Update and Hot Topics
•
Changes to Medicare Part D subsidy — An entity offering retiree prescription coverage that is
equal to or greater than the Medicare prescription coverage is entitled to a subsidy. Before the
Act, entities were allowed to deduct the entire cost of providing the retiree prescription coverage
even though a portion was offset by the subsidy. However, under the Act, the tax deductible
prescription coverage is now reduced by the amount of the subsidy. As a result, some entities
will be forced to take a noncash charge in connection with the impairment of their deferred tax
assets related to the Medicare Part D subsidy. Because of the increased cost resulting from the
elimination of the deductibility of the Medicare Part D subsidy, entities will need to determine
whether changes to their current retiree medical benefits are warranted. To the extent that
such charges are taken and they are material, disclosure about the charge may be needed in an
entity’s financial statements and MD&A.
•
Excise tax on “Cadillac plans” — Beginning in 2018, the Act imposes a nondeductible 40 percent
excise tax on the “excess benefit” provided under Cadillac plans. An excess benefit is a benefit
whose annual cost exceeds $10,200 a year for individuals or $27,500 for families. The excise tax
will make Cadillac plans significantly more expensive than they are currently, and the tax could be
44
a factor that entities take into account as they determine whether to change or continue to offer
Cadillac plans. Disclosure may be required if entities start modifying their Cadillac plans to avoid
the excise tax.
•
Disclosure controls and procedures, and ICFR — The Act may cause a public entity to implement
new, or modify existing, ICFR and disclosure controls and procedures.
SEC Support of Convergence and Global Accounting Standards
SEC Publishes Work Plan for Moving Forward With IFRSs for U.S. Issuers
On February 24, 2010, the SEC issued a statement expressing its strong commitment to the development
of a single set of high-quality globally accepted accounting standards. The statement emphasizes the
importance of the FASB’s and IASB’s convergence efforts and of the completion of such efforts in
accordance with the boards’ current time table (i.e., by mid-2011). It directs the SEC staff to execute a
work plan addressing specific areas of concern that have been highlighted in comment letters to the SEC.
The purpose of the work plan is to provide the Commission with the information it needs to make a wellinformed decision regarding the use of IFRSs by U.S. issuers. The statement and work plan do not contain
any specific adoption dates or transition methods (e.g., wholesale conversion, a standard-by-standard
phase-in, continued convergence). This approach is consistent with Chairman Schapiro’s remarks that the
FASB’s and IASB’s current convergence projects “must first be successfully completed” before a final ruling
can be made on the use of IFRSs by U.S. issuers.
To provide information about the work plan and the SEC’s progress, the Commission added a page to its
Web site that focuses on its considerations related to incorporating IFRSs into the U.S. financial reporting
system for domestic issuers. The new page contains various SEC documents related to IFRSs, and while
the SEC did not solicit formal feedback on the work plan, the page offers a mechanism for constituents to
provide comments to the Commission.
In an effort to obtain further feedback from constituents, on August 12, 2010, the SEC published two
releases (33-9133 and 33-9134) requesting comment on a number of topics related to whether the
Commission should incorporate IFRSs into the financial reporting system for U.S. issuers. Comments on
the releases were due by October 18, 2010.
On October 29, 2010, in accordance with the SEC’s commitment to provide frequent public progress
reports beginning no later than October 2010, the SEC staff issued its first public progress report on the
staff’s efforts and observations to date under the work plan. For each of the six areas of concern identified
in the work plan, the progress report summarizes the plan’s objectives as well as the SEC staff’s efforts in
executing it and its preliminary observations to date, as applicable.
As noted in the progress report, “[m]any of the Staff’s efforts are currently in process and are not expected
to be completed until 2011, particularly as they relate to consideration of the sufficient development and
application of IFRS for the U.S. domestic reporting system and the independence of standard setting for
the benefit of investors.” The SEC staff intends to continue to report periodically on the status of the work
plan.
After the FASB’s and IASB’s current convergence projects are completed, the Commission will determine
whether to incorporate IFRSs into the U.S. financial reporting system. The February 2010 statement
indicates that this determination will be in 2011, in line with the timeline in the SEC’s 2008 proposed
roadmap for IFRSs adoption. The February 2010 statement also removes the early adoption option
presented in the proposed roadmap for periods beginning on or after December 15, 2009; however, the
Section 2: SEC Update and Hot Topics
45
statement leaves open the possibility for an early adoption option upon a final decision in 2011. Decisions
on these issues will be made in the context of the information received as part of executing the work plan.
The statement notes that if in 2011 the SEC votes to incorporate IFRSs into the financial reporting system
for U.S. issuers, it will do so through the official rulemaking process, with a proposed rule that will be
open for comment. The SEC will consider the comments before finalization of the rule and allow sufficient
transition time, with U.S. issuers reporting under such a system no earlier than 2015.
Note that while this timetable is preliminary, the initial roadmap proposed by the Commission in 2008
did not provide any relief from the SEC’s current reporting requirements related to presentation of three
years of comparative information. If these requirements are maintained, U.S. issuers may have to present
comparative IFRS information in their 2013 financial statements.
Section 2: SEC Update and Hot Topics
46
Section 3
FASB and IASB Update
Introduction
This section discusses recently issued FASB standards and proposals, certain joint projects between
the FASB and IASB, and current and proposed international standards issued by the IASB that are not
the result of joint projects between the IASB and FASB. Other standard-setting activities, including
consolidations, transfers of financial assets, loan accounting, impairments and TDRs, fair value, and
accounting for financial instruments are covered in Section 1. Standard-setting activity that is primarily
applicable only to a specific industry sector is addressed within the applicable sector supplement.
FASB Accounting Standard Updates
Lending Arrangements of Entity’s Own Shares in Contemplation of Convertible
Debt Issuance or Other Financing (ASU 2009-15)
On October 13, 2009, the FASB issued ASU 2009-15, which reflects the consensus reached by the EITF in
Issue 09-1.
Entities that issue convertible debt may also execute share-lending arrangements on their own shares
for below-market consideration (usually for the par value of the shares lent to the investment bank) with
the investment bank underwriting that issuance. These share-lending arrangements typically require the
investment bank to return the shares to the issuer within a specified period and reimburse the issuer for
any dividends paid on those shares while the lending arrangement is outstanding. Although the sharelending arrangement with the underwriter is executed at below-market rates, the issuer benefits under the
arrangement by completing the issuance of the convertible debt for a lower underwriting fee or a lower
interest rate than would otherwise be attainable.
The ASU requires an entity that enters into a share-lending arrangement on its own shares (that are
classified in equity pursuant to other authoritative accounting guidance) in contemplation of a convertible
debt issuance (or other financing) to initially measure the share-lending arrangement at fair value and
treat it as an issuance cost with an offset to additional paid-in capital. The entity would exclude the shares
borrowed under the share-lending arrangement from basic and diluted EPS. If, however, dividends on the
loaned shares are not reimbursed to the entity, those dividend amounts and any participation rights in
undistributed earnings attributable to the loaned shares would reduce the income available to common
shareholders in a manner consistent with the two-class method.
If it becomes probable that the share-lending arrangement counterparty will default on the arrangement
(not return the entity’s shares within the specified period), the issuing entity should record a loss in
current earnings that is equal to the fair value of the shares outstanding less any recoveries. The entity will
continue to adjust the loss until actual default. On the basis of the guidance for contingently returnable
shares, upon default (not when default is probable), the issuing entity will include the shares outstanding
under the share-lending arrangement (net of any share recoveries) in basic and diluted EPS.
The ASU also requires entities to provide certain disclosures about the share-lending arrangement,
including (1) a description of the share-lending arrangement, including all significant terms; (2) the entity’s
reason for entering into the arrangement; (3) the maximum potential economic loss as of the balance
sheet date (e.g., the fair value of the loaned shares currently outstanding); (4) the EPS treatment of the
shares underlying the arrangement; (5) the unamortized carrying amount of issuance costs associated with
the share-lending arrangement; and (6) if applicable, the current income statement and expected effect
on EPS of a default by the counterparty.
Section 3: FASB and IASB Update
47
The ASU is effective for new share-lending arrangements issued in periods beginning on or after June
15, 2009. For all other share-lending arrangements, the ASU is effective for fiscal years, and interim
periods within those fiscal years, beginning on or after December 15, 2009. The ASU should be applied
retrospectively to arrangements that are outstanding on the effective date.
Distributions to Shareholders With Components of Stock and Cash (ASU 2010-01)
On January 5, 2010, the FASB issued ASU 2010-01, which reflects the consensus reached by the EITF in
Issue 09-E. The ASU “affects entities that declare dividends to shareholders that may be paid in cash or
shares at the election of the shareholders with a potential limitation on the total amount of cash that all
shareholders can elect to receive in the aggregate.”
The ASU requires that in calculating EPS, an entity should account for the share portion of the distribution
as a stock issuance and not as a stock dividend. In other words, the entity will include the shares issued or
issuable as part of a distribution in basic EPS prospectively. From the date the entity commits itself to pay
a dividend that has components of cash and shares to the time the dividend is actually distributed, the
entity needs to consider other GAAP in accounting for the commitment to distribute cash and shares as
a liability and that commitment’s effect on basic EPS, diluted EPS, or both. ASC 480-10-25-14 requires an
entity to record a liability for any obligation that may be settled in a variable number of equity shares.
The ASU is effective for interim and annual periods ending on or after December 15, 2009, and should be
applied retrospectively to all prior periods.
Subsequent Events (ASU 2010-09)
On February 24, 2010, the FASB issued ASU 2010-09, which contains amendments to certain recognition
and disclosure requirements of ASC 855. The ASU amends ASC 855 to indicate that the period through
which subsequent events are evaluated is based on whether an entity is (1) an SEC filer or a conduit debt
obligor or (2) another entity. If an entity is either an SEC filer or a conduit debt obligor, the ASU requires
it to evaluate subsequent events through the date on which the financial statements are issued. All
other entities are required to evaluate subsequent events through the date their financial statements are
available to be issued. This evaluation may require significant judgment, and an entity’s determination is
an accounting policy election that, once made, should be applied consistently.
Date Disclosure Exemption for SEC Filers
The ASU amends ASC 855-10-50-1 to clarify that SEC filers are not required to disclose the date through
which subsequent events have been evaluated and whether that date is the date the financial statements
were issued or available to be issued. All entities other than SEC filers must still comply with the disclosure
requirements. However, the date-disclosure exemption does not relieve management of an SEC filer from
its responsibility to evaluate subsequent events through the date on which financial statements are issued.
That is, the evaluation of subsequent events must still be performed.
The ASU defines “revised financial statements” as “financial statements revised either as a result of
correction of an error or retrospective application of [U.S. GAAP].” Upon revising its financial statements,
an entity is required to update its evaluation of subsequent events through the date the revised financial
statements are issued or are available to be issued. The ASU also notes that non-SEC filers should disclose
“both the date that the financial statements were issued or available to be issued and the date the
revised financial statements were issued or available to be issued” if the financial statements have been
revised. An SEC filer is not required to disclose in its revised financial statements the date through which
subsequent events have been evaluated.
Section 3: FASB and IASB Update
48
Effective Date
For all entities (except conduit debt obligors), the ASU was effective upon issuance for financial statements
that are (1) issued or are available to be issued or (2) revised. For conduit debt obligors, the ASU is
effective for interim and annual periods ending after June 15, 2010.
Scope Exception Related to Embedded Credit Derivatives (ASU 2010-11)
On March 5, 2010, the FASB issued ASU 2010-11, which addresses application of the embedded
derivative scope exception in ASC 815-15-15-8 and 15-9. The ASU primarily affects entities that hold or
issue investments in financial instruments that contain embedded credit derivative features (including
entities that consolidate a VIE that issues financial instruments containing embedded credit derivative
features), and its provisions could affect the accounting for many types of investments, including CDOs
and synthetic CDOs. However, other entities may also benefit from the ASU’s transition provisions, which
permit entities to make a special one-time election to apply the fair value option to any investment
in a beneficial interest in securitized financial assets, regardless of whether such investments contain
embedded derivative features.
Clarification of Scope Exception
The amendments to ASC 815-15-15-8 and 15-9 clarify that the “transfer of credit risk that is only in the
form of subordination of one financial instrument to another . . . is an embedded derivative feature that
should not be subject to potential bifurcation [analysis under ASC] 815-10-15-11 and [ASC] 815-15-25”
(emphasis added). Consequently, embedded credit derivative features in a financial instrument other
than those resulting from subordination do not qualify for the scope exception. The final ASU cites three
specific examples of embedded derivative features that would not qualify for the scope exception:
•
An embedded derivative feature related to another type of risk (including another type of credit
risk).
•
A derivative feature embedded in a tranche of a securitized financial instrument whose holder
could be compelled to make additional future payments (i.e., the holder’s risk goes beyond
merely receiving reduced cash flows for its investment) even if the possibility of such an outcome
is remote. The Board believes that when an interest’s terms expose the investor to possibly
losing more than its initial investment, the related transfer of credit risk is not only in the form of
subordination of one financial instrument to another.
•
A derivative feature embedded in an interest in a single-tranche securitization vehicle. Because
there is no subordination in such a vehicle, it cannot qualify for the scope exception.
When the scope exception cannot be applied, the investor must assess the embedded derivative feature
for potential bifurcation and separate accounting under ASC 815-10-15-11 and ASC 815-15-25.
If an entity determines that its investment has (1) an embedded credit derivative feature related to
subordination that qualifies for the scope exception and (2) a second embedded derivative feature that
requires bifurcation (e.g., a feature related to a written credit default swap held in the securitization trust),
the entity would determine the fair value of the derivative that must be bifurcated on the basis of the
derivative’s expected cash flows as affected by the subordination provisions even though no separate
derivative is recognized for the embedded credit derivative feature created by subordination.
Section 3: FASB and IASB Update
49
The chart below illustrates the application of the scope exception in ASU 2010-11:
Beneficial Interest
(Assume that (1) the fair value option has not
been applied to the interest and (2) the interest
is not a derivative in its entirety.)
Is this an interest
in a single tranche
structure?
Yes
No
Yes
All embedded
derivative features
would need to
be evaluated for
possible bifurcation.
All embedded
derivative features,
including any
subordination
features, would
need to be
evaluated for
possible bifurcation.
Is there a possibility,
however remote,
that the investor
could be required to
pay more than the
initial investment?
Yes
• Embedded credit
derivative feature
created by the
subordination of one
tranche to another
qualifies for the scope
exception under ASC
815-15-15-9.
No
In the securitization
structure, is
there a transfer
of risk between
tranches due to
subordination?
No
Analyze all
embedded features
for possible
bifurcation.
• Analyze all other
embedded features for
possible bifurcation.
Disclosures
Although the ASU does not create any new disclosure requirements, it clarifies that the disclosure
requirements detailed in ASC 815-10-50-4K for sellers of credit derivatives do not apply to embedded
credit derivative features related only to subordination that qualify for the scope exception in ASC 815-1515-9. However, the disclosure requirements in ASC 815-10-50-4K will continue to apply to other credit
derivatives, including those embedded in hybrid contracts.
Section 3: FASB and IASB Update
50
Effective Date and Transition
The ASU is effective on the first day of the first fiscal quarter beginning after June 15, 2010. Therefore, for
a calendar-year-end entity, the ASU becomes effective on July 1, 2010. Early adoption is permitted at the
beginning of any fiscal quarter beginning after March 5, 2010.
Upon adoption, an entity must assess certain preexisting contracts to determine whether the accounting
for such contracts is consistent with the amended guidance in the ASU; however, an entity can avoid
having to perform such assessments if it opts instead to apply the fair value option to those contracts.
Upon adoption of the ASU, an entity “may elect the fair value option for any investment in a beneficial
interest in a securitized financial asset [and] measure that investment in its entirety at fair value (with
changes in fair value recognized in earnings)” (emphasis added). Although the ASU’s guidance is written
from the perspective of the holder of the investment, the issuer of the interest also would be permitted to
apply the fair value option. This fair value election is determined instrument by instrument, is irrevocable,
and must be “supported by documentation completed by the beginning of the fiscal quarter of initial
adoption.” Any cumulative unrealized gains and losses associated with contracts to which the fair value
option is applied will be reported as part of the cumulative-effect adjustment to beginning retained
earnings for the period of adoption.
The transition provisions for contracts that are reassessed at adoption (for which the fair value option is
not elected) are as follows:
•
Contracts containing embedded derivative features that no longer qualify for the scope
exception — An entity must assess whether the embedded credit derivative feature or features
require bifurcation. If bifurcation is required, the carrying amounts of the components of the
hybrid instrument are determined as though a pro forma bifurcation occurred at the inception of
the hybrid instrument and the host contract was subsequently accounted for up to the date of
adoption of the ASU. Any difference between the total carrying amount of the components of
the newly bifurcated hybrid instrument and the carrying amount of the hybrid instrument before
bifurcation will be recognized as a cumulative-effect adjustment to beginning retained earnings
for the period of adoption.
•
Previously bifurcated contracts containing embedded derivative features that now qualify for the
scope exception — An entity would recognize the recombined hybrid instrument at a carrying
value equal to the sum of the carrying values of each individual component on the date of
adoption. No cumulative-effect adjustment to beginning retained earnings will be recognized.
The ASU specifies that an entity must disclose “the gross gains and gross losses that make up the
cumulative-effect adjustment, determined on an instrument-by-instrument basis.” Such gains and losses
are composed of (1) cumulative unrealized gains and losses associated with contracts to which the fair
value option is applied and (2) gains and losses arising from the pro forma bifurcation applied to hybrids
for which the entity did not opt to apply the fair value option. An entity may also choose to separately
disclose the gains and losses associated with either component (1) or (2). Prior periods cannot be restated.
Loan Modifications When the Loan Is Part of a Pool That Is Accounted for as a
Single Asset (ASU 2010-18)
On April 29, 2010, the FASB issued ASU 2010-18. The ASU affects entities that modify a loan that is
currently accounted for as part of a pool of loans that, when acquired, had deteriorated in credit quality,
as outlined in ASC 310-30.
Section 3: FASB and IASB Update
51
The ASU indicates that a modification to a loan that is part of a pool accounted for under ASC 310-30
should not result in removal of the loan from the pool. This restriction on removal of a loan from a pool
includes loan modifications that would otherwise qualify as TDRs under ASC 310-40 had the loan not
been part of a pool. Therefore, entities should not evaluate whether a modification of loans (that are part
of a pool accounted for under ASC 310-30) meets the criteria for a TDR in ASC 310-40.
Modified loans should not be removed from the pool unless either of the following conditions from ASC
310-30-40-1 is met:
a. The investor sells, forecloses, or otherwise receives assets in satisfaction of the loan.
b. The loan is written off.
The ASU also permits a one-time election for entities to change the unit of accounting from a pool basis
to an individual loan basis. Such an election would be applied on a pool-by-pool basis. This would allow
entities that make the election to apply the guidance in ASC 310-40 on TDRs to individual loans in the
event of future loan modifications.
This ASU is effective for any modifications of a loan or loans accounted for within a pool in the first
interim or annual reporting period ending on or after July 15, 2010, and will be applied prospectively.
Disclosures About the Credit Quality of Financing Receivables and Allowance for
Credit Losses (ASU 2010-20)
On July 21, 2010, the FASB issued ASU 2010-20, which amends ASC 310 by requiring more robust and
disaggregated disclosures about the credit quality of an entity’s financing receivables and its allowance
for credit losses. The objective of enhancing these disclosures is to improve financial statement users’
understanding of (1) the nature of an entity’s credit risk associated with its financing receivables and (2)
the entity’s assessment of that risk in estimating its allowance for credit losses as well as changes in the
allowance and the reasons for those changes.
Scope and Potential Impact
The ASU applies to all public and nonpublic entities with financing receivables, which are defined as a
contractual right to receive money on demand or on fixed or determinable dates that is recognized as
an asset in the entity’s statement of financial position. Thus, examples of financing receivables include
loans, trade accounts receivable, notes receivable, credit cards, and lease receivables (other than operating
leases).
Under the ASU, certain types of financing receivables are not subject to the new and amended disclosure
requirements, including (1) short-term trade accounts receivable (other than credit card receivables); (2)
receivables measured at fair value, with changes in fair value recorded in earnings; and (3) receivables
measured at the lower of cost or fair value. The ASU also specifically excludes from the definition of
financing receivables (1) debt securities, (2) unconditional promises to give, and (3) acquired beneficial
interests or the transferor’s beneficial interests in securitized financial assets.
New and Amended Disclosure Requirements
The ASU’s new and amended disclosure requirements focus on the following five topics:
1. Nonaccrual and past due financing receivables . . .
2. Allowance for credit losses related to financing receivables . . .
Section 3: FASB and IASB Update
52
3. Impaired loans [individually evaluated for impairment]
4. Credit quality information . . .
5. Modifications.
The disclosures above are to be presented at a specified level of aggregation, with the allowance for
credit losses and qualitative information related to modifications of financing receivables presented at
the portfolio-segment level. A portfolio segment is defined in the ASU as the “level at which an entity
develops and documents a systematic methodology to determine its allowance for credit losses.” For
example, a portfolio segment may be defined by (1) the different types of financing receivables (e.g.,
mortgage loans, auto loans), (2) the industry to which the financing receivable relates, or (3) the differing
risk rates.
An entity must provide all other disclosures from the list above by class of financing receivable, which is
generally a disaggregation of a portfolio segment and is determined on the basis of the nature and extent
of an entity’s exposure to credit risk arising from financing receivables. At a minimum, classes of financing
receivables must be first (1) segregated on the basis of the measurement attribute (amortized cost and
present value of amounts to be received) and then (2) disaggregated to the level that an entity uses when
assessing and monitoring the risk and performance of the portfolio (including the entity’s assessment of
the risk characteristics of the financing receivables).
The following table provides greater detail of the disclosures listed above by category.
Category Does Not Apply To
New and Amended Disclosures
Nonaccrual
and Past
Due
Financing
Receivables
By class of financing receivable:
1.Short-term trade accounts
receivable (except for
credit card receivables).
2.Financing receivables
measured at fair value,
with changes in fair value
recorded in earnings.
3.Financing receivables
measured at lower of cost
or fair value.
4.Loans acquired with
deteriorated credit quality.
Section 3: FASB and IASB Update
1.In an entity’s summary of significant accounting policies, its policies for:
• Placing financing receivables on nonaccrual status.
• Recording payments received on nonaccrual financing receivables.
• Resuming accrual of interest.
• Determining past due or delinquency status.
2.The “recorded investment in financing receivables on nonaccrual status” and
those “past due 90 days or more and still accruing.”
3.An analysis of the age of the recorded investment in financing receivables that
are past due (determined on the basis of the entity’s policy), at the end of the
reporting period.
53
Category Does Not Apply To
New and Amended Disclosures
Allowance
for Credit
Losses
Related to
Financing
Receivables
By portfolio segment:
1.Short-term trade accounts
receivable (except for
credit card receivables).
1.A description of the “accounting policies and methodology used to estimate
the allowance for credit losses.”
2.Financing receivables
measured at fair value,
with changes in fair value
recorded in earnings.
2.A description of management’s “policy for charging off uncollectible financing
receivables.”
3.Financing receivables
measured at lower of cost
or fair value.
4.For each income statement presented, the quantitative effect on an entity’s
current-period provision for credit losses resulting from an entity changing its
accounting policy and methodology used to estimate the allowance for credit
losses from the prior period.
4.Lessor’s net investments in
leveraged leases.
3.“The activity in the allowance for credit losses for each period.”
5.“The amount of any significant purchases of financing receivables during each
reporting period.”
6.“The amount of any significant sales of financing receivables or reclassifications
of financing receivables to held for sale during each reporting period.”
7.“The balance in the allowance for credit losses at the end of each period
disaggregated on the basis of the entity’s impairment method” (i.e., separate
presentation for financing receivables that are evaluated collectively for
impairment (under ASC 450-20), those that are evaluated individually for
impairment (under ASC 310-10-35), and loans acquired with deteriorated
credit quality (under ASC 310-30)).
8.“The recorded investment in financing receivables at the end of each period
related to each balance in the allowance for credit losses,” disaggregated
on the basis of impairment method (i.e., separate presentation for financing
receivables that are evaluated collectively for impairment (under ASC 450-20),
those that are evaluated individually for impairment (under ASC 310-10-35),
and loans acquired with deteriorated credit quality (under ASC 310-30)).
Impaired
Loans
(Individually
Evaluated for
Impairment)
Editor’s Note: Impaired
loan disclosures do not apply
to loans measured at (1) fair
value, with changes in fair
value recorded in earnings,
and (2) loans measured at
the lower of cost or fair value
because credit losses have
already been reflected in
earnings.
By class of financing receivable:
1.The accounting for impaired loans.
2.The amount of impaired loans.
3.The recorded investment in the impaired loans, including the recorded
investment for which there is a related allowance (and the allowance amount
itself) and for which there is no related allowance.
4.The total unpaid principal balance of the impaired loans.
5.“The entity’s policy for recognizing interest income on impaired loans,
including how cash receipts are recorded.”
6.For each income statement presented, the “average recorded investment in
the impaired loans,” “the related amount of interest income recognized during
the time . . . the loans were impaired,” and the “amount of interest income
recognized using a cash-basis method of accounting during the time within
that period that the loans were impaired, if practicable.”
7.The entity’s policy for determining which loans the entity individually assesses
for impairment.
8.The factors the entity considered in determining that the loan is impaired.
Section 3: FASB and IASB Update
54
Category Does Not Apply To
New and Amended Disclosures
Credit
Quality
Information
By class of financing receivable:
1.Short-term trade accounts
receivable (except for
credit card receivables).
2.Financing receivables
measured at fair value,
with changes in fair value
recorded in earnings.
3.Financing receivables
measured at lower of cost
or fair value.
Modifications1
1.Short-term trade accounts
receivable (except for
credit card receivables).
2.Financing receivables
measured at fair value,
with changes in fair value
recorded in earnings.
3.Financing receivables
measured at lower of cost
or fair value.
4.Loans acquired with
deteriorated credit quality
that are accounted for
within a pool.
1.Quantitative and qualitative information about the credit quality of financing
receivables, including:
• A description of the credit quality indicator.
• The recorded investment in financing receivables by credit quality indicator.
• For each credit quality indicator, the date or range of dates in which the
information was updated for that credit quality indicator.
2.If internal risk ratings are disclosed, the entity must provide qualitative
information about how those internal risk ratings relate to the likelihood of
loss.
For each income statement presented:
1.For TDRs of financing receivables that occurred during the period:
• Qualitative and quantitative information, by class of financing receivable,
about (a) how “the financing receivables were modified” and (b) the
“financial effects of the modifications.”
• Qualitative information by portfolio segment about how “modifications
are factored into the determination of the allowance for credit losses.”
2.For “financing receivables modified as troubled debt restructurings within the
previous 12 months and for which there was a payment default during the
period”:
• Qualitative and quantitative information by class of financing receivable,
including the types and the amounts of financing receivables that
defaulted.
• Qualitative information by portfolio segment “about how such defaults are
factored into the determination of the allowance for credit losses.”
Effective Date and Transition
For public entities, the new and amended disclosures that relate to information as of the end of a
reporting period will be effective for the first interim or annual reporting periods ending on or after
December 15, 2010. That is, for calendar-year-end public entities, most of the new and amended
disclosures in the ASU would be effective for the quarter and year ending December 31, 2010. However,
the disclosures that include information for activity that occurs during a reporting period will be effective
for the first interim or annual periods beginning after December 15, 2010. Those disclosures include (1)
the activity in the allowance for credit losses for each period and (2) disclosures about modifications of
financing receivables. For calendar-year-end public entities, those disclosures would be effective for the
first quarter of 2011.
The FASB has separately proposed a limited-scope deferral for those disclosures related to modifications
of financing receivables (i.e., TDRs) to synchronize the effective date with the FASB’s project on TDR
classification. The expected effective date for the TDR classification project will be for interim and annual
periods ending after June 15, 2011, for public entities.
For nonpublic entities, all disclosures will be required for annual reporting periods ending on or after
December 15, 2011. That is, for calendar-year-end nonpublic entities, the new and amended disclosures
in the ASU would be effective for the year ending December 31, 2011.
This disclosure guidance applies “only to a creditor’s troubled debt restructurings of financing receivables” and to “a creditor’s modification of a lease
receivable that meets the definition of a troubled debt restructuring.”
1
Section 3: FASB and IASB Update
55
Comparative disclosures for earlier reporting periods that ended before initial adoption are encouraged
but not required. However, the ASU requires entities to provide comparative disclosures for reporting
periods that end after initial adoption.
Proposed FASB Accounting Standard Updates
Disclosure of Certain Loss Contingencies
On July 20, 2010, the FASB issued a proposed ASU that would (1) expand the scope of loss contingencies
subject to disclosure to include certain remote contingencies; (2) increase the quantitative and qualitative
disclosures entities must provide to enable users to assess the “nature, potential magnitude, and potential
timing (if known)” of loss contingencies; and (3) for public entities, require a tabular reconciliation for
changes in amounts recognized for loss contingencies.
Scope
The proposed ASU would apply to all loss contingencies under ASC 450-20 and ASC 805. Regarding
loss contingencies, the proposed ASU states that an “entity shall disclose qualitative and quantitative
information . . . to enable financial statement users to understand” the “nature of the loss contingencies,”
their “potential magnitude,” and their “potential timing (if known).”
Accordingly, an entity’s disclosures about a contingency should “be more extensive as additional
information about a potential unfavorable outcome becomes available” and as the contingency nears
resolution. Disclosures of similar contingencies may be aggregated so that disclosures are understandable
and not too detailed.
The proposed amendments would not change an entity’s requirement to recognize loss contingencies
that are probable and to disclose loss contingencies that are at least reasonably possible (although
the information actually disclosed would most likely change). However, certain remote contingencies
would require disclosure if, because of their nature, potential magnitude, or potential timing (if known),
disclosure would be “necessary to inform users about the entity’s vulnerability to a potential severe
impact” (“special remote”). ASC 275-10-20 defines severe impact, in part, as a “significant financially
disruptive effect on the normal functioning of an entity. Severe impact is a higher threshold than
material. . . . The concept of severe impact, however, includes matters that are less than catastrophic.”
Qualitative Disclosures
Entities would be required to disclose the following qualitative information about a loss contingency that
meets the threshold for disclosure (i.e., probable, reasonably possible, or special remote) or classes
(types) of similar contingencies:
•
Information about the nature and risks of the loss contingency.
•
For individually material contingencies, information that is sufficiently detailed to enable users to
“obtain additional information from publicly available sources such as court records.” This could
include:
1. The name of the court or agency in which the proceedings are pending
2. The date instituted
3. The principal parties to the proceedings
Section 3: FASB and IASB Update
56
4. A description of the factual basis alleged to underlie the proceedings
5. The current status of the litigation contingency.
•
When applicable, the basis for aggregation and “information that would enable financial
statement users to understand the nature, potential magnitude, and potential timing (if known)
of loss.”
In addition, for asserted litigation contingencies, entities should make the following disclosures:
•
During early stages, the contentions of the parties (e.g., the basis for the claim amount, the
amount of damages claimed, the basis for the entity’s defense or that the entity has not yet
formulated its defense).
•
More extensive disclosures as additional information about a potential unfavorable outcome
becomes available (e.g., as progress is made toward resolution, or as the likelihood and
magnitude of a loss increase).
•
For individually material asserted litigation contingencies, the anticipated timing/next steps (if
known).
Quantitative Disclosures
For all loss contingencies that meet the threshold for disclosure (i.e., probable, reasonably possible, or
special remote), an entity would disclose:
•
Publicly available quantitative information (e.g., the amount claimed by the plaintiff or damages
indicated through expert witness testimony).
•
Other nonprivileged information that would help users understand the potential magnitude of
the possible loss.
•
Information about potential recoveries from insurance and other sources, but only if (1) such
information “has been provided to the plaintiff(s) in a litigation contingency [or] is discoverable
by either the plaintiff or a regulatory agency” or (2) a receivable has been recognized. “If the
insurance company has denied, contested, or reserved its rights related to the entity’s claim for
recovery, an entity shall disclose that fact.”
In addition, if a loss contingency is probable or reasonably possible, an entity would disclose an
estimate of the possible loss or range of loss and the amount accrued (if any), unless an estimate cannot
be made, in which case the entity would state that fact and explain its reasons. If an entity has insurance
or other recoveries related to its loss contingencies, the potential recovery amounts are not netted (offset)
against amounts accrued for loss contingencies. The proposed ASU would also require public entities to
present a table reconciling the total aggregate amount of contingencies recognized in the statement of
financial position at the beginning and end of the period. Presentation of the table would be required
for each period for which an income statement is presented. The reconciliation should be presented
separately for each class of contingencies so that dissimilar contingencies are not aggregated.
In addition to the beginning and ending balances, the table would show the following:
Section 3: FASB and IASB Update
•
Increases in amount accrued for new loss contingencies recognized.
•
Increases for changes in estimates for amounts previously recognized.
57
•
Decreases for changes in estimates for amounts previously recognized.
•
Decreases in cash payments or other forms of settlement.
Further, an entity would be required to provide a qualitative description of any significant activity included
in the table. The entity must also disclose which line item in the statement of financial position contains
the loss contingency amounts. An entity would not need to disclose contingencies that arise and are
resolved in the same period (except those recognized in a business combination).
Effective Date and Transition
For public entities, the ED proposed that the amendments would be effective for fiscal years ending after
December 15, 2010, and interim and annual periods in subsequent fiscal years. For nonpublic entities,
the proposed amendments would be effective for the first annual period beginning after December
15, 2010, and for interim periods of fiscal years after the first annual period. Early adoption would be
permitted. Comparative disclosures would only be required for periods ending after initial adoption. In
recent deliberations, however, the FASB clarified that the amendments will not be effective for 2010
annual financial statements of public calendar-year-end entities as originally proposed. The Board will
discuss a revised effective date in future redeliberations, which are currently expected to begin in the
second half of 2011.
Reconsideration of Effective Control for Repurchase Agreements
On November 3, 2010, the FASB issued a proposed ASU that amends the guidance in ASC 860 on
accounting for certain repurchase agreements (“repos”). Specifically, the amendments propose to
eliminate the collateral maintenance provision that a company uses to determine whether a transfer of
financial assets in a repo transaction is accounted for as a sale or as a secured borrowing. The elimination
of the collateral maintenance provision from a company’s assessment of effective control over transferred
financial assets in a repo may cause more repos to be accounted for as secured borrowings rather than as
sales.
The proposed ASU would be effective for interim and annual periods beginning after the final ASU is
issued (expected in the first quarter of 2011) and would be applied prospectively to new transfers and
existing transactions that are modified after the effective date. Early adoption would be prohibited.
Comments on the proposed ASU are due by January 15, 2011.
Joint Projects of the FASB and IASB
Statement of Comprehensive Income
On May 26, 2010, the FASB issued for public comment a proposed ASU that would amend ASC 220
(formerly Statement 130) by requiring all components of comprehensive income to be reported in a
continuous financial statement. The proposed ASU applies to all entities that provide a full set of financial
statements that report financial position, results of operations, and cash flows. In addition, investment
companies, defined benefit pension plans, and other employee benefit plans that are exempt from the
requirements to provide a statement of cash flows would be within the scope of the new guidance. Under
the proposed ASU, an entity would do the following:
•
Section 3: FASB and IASB Update
Report comprehensive income and its components in a continuous financial statement (which
must be displayed as prominently as other full sets of financial statements) in two sections: (a) net
income and (b) OCI.
58
•
Display a total for each section of net income and OCI.
•
Display each component of net income and each component of OCI in the financial statement.
The proposed ASU does not change the items that must be reported in OCI, nor does it change the option
for a preparer to show components of comprehensive income net of the effect of income taxes as long
as the preparer shows the tax effect for each component in the notes to the financial statement or on the
face of the statement of comprehensive income.
On May 26, 2010, the IASB also issued an ED on the presentation of OCI that is largely the same as
the FASB’s proposed ASU. The FASB plans to align the ASU’s effective date with that of the IASB in its
proposed ASU on financial instruments, which will be determined when it considers the comments
received on the proposed standards. The FASB and IASB expect to issue a final converged standard in the
first quarter of 2011.
Financial Instruments With Characteristics of Equity
This project on improving and simplifying the financial reporting for financial instruments considered to
have one or more characteristics of equity has been ongoing for a number of years. It was formally added
as a joint convergence project in July 2008.
In their deliberations, the two boards developed a new classification approach that was expected to be
exposed for public comment in early 2011. However, after providing a staff draft of the ED to certain
constituents, the boards received a significant number of comments. The overriding concern was that the
proposal lacked key principles and would result in inconsistent classification, practice issues related to the
classification criteria, and increased structuring opportunities.
In October 2010, the FASB and IASB met to consider how to proceed with the project. Given the concerns
raised about the draft proposal and the significant effort necessary for the boards to deliberate the issues,
the boards agreed to defer further deliberation on this project until June 2011 at the earliest.
Revenue Recognition: Revenue From Contracts With Customers
On June 24, 2010, the FASB and IASB jointly issued a proposed ASU that gives entities a single
comprehensive model to use in reporting information about the amount and timing of revenue resulting
from contracts to provide goods or services to customers. The proposed ASU, which would apply to
any entity that enters into contracts to provide goods or services, would supersede most of the current
revenue recognition guidance. The effective date has yet to be determined.
Scope
The scope of the proposed ASU includes all contracts with customers except (1) those within the scope
of ASC 840 (on leases) or ASC 944 (on insurance), (2) certain contractual rights or obligations within the
scope of other ASC topics (including ASC 310 on receivables, ASC 320 on debt and equity securities, ASC
405 on extinguishment of liabilities, ASC 470 on debt, ASC 815 on derivatives and hedging, ASC 825
on financial instruments, and ASC 860 on transfers and servicing), (3) guarantees (other than product
warranties) within the scope of ASC 460, and (4) nonmonetary exchanges whose purpose is to facilitate a
sale to another party.
Section 3: FASB and IASB Update
59
Key Provisions
The core principle under the proposed ASU is that an entity must “recognize revenue to depict the transfer
of goods or services to customers in an amount that reflects the consideration that it receives, or expects
to receive, in exchange for those goods or services.” In applying the provisions of the proposed ASU to
contracts within its scope, an entity would:
(a) identify the contract(s) with a customer;
(b) identify the separate performance obligations in the contract;
(c) determine the transaction price;
(d) allocate the transaction price to the separate performance obligations; and
(e) recognize revenue when the entity satisfies each performance obligation.
Disclosures
The proposed ASU requires entities to disclose both (1) quantitative and qualitative information about the
amount, timing, and uncertainty of revenue (and related cash flows) from contracts with customers and
(2) the judgment, and changes in judgment, they exercised in applying the provisions of the proposed
ASU. The disclosures required by the proposed ASU would significantly expand those currently required by
existing revenue standards and would include:
•
Information about the nature of customer contracts and related accounting policies.
•
A disaggregation of reported revenue (in categories that best depict how the amount, timing,
and uncertainty of revenues and cash flows are affected by economic characteristics).
•
A reconciliation of the beginning and ending contract assets and liabilities.
•
Information about performance obligations (e.g., types of goods or services, payment terms,
timing).
•
Information about onerous contracts, including the extent and number of such contracts and the
reasons they became onerous.
•
A description of the principal judgments used in accounting for contracts with customers.
•
Information about the methods, inputs, and assumptions used in determining and allocating
transaction prices.
Amendments for Common Fair Value Measurement and Disclosure Requirements
in U.S. GAAP and IFRSs
On June 29, 2010, the FASB issued a proposed ASU on fair value measurement and disclosure that is the
result of the FASB’s and IASB’s joint project to develop a single, converged fair value framework. Under
the proposal, fair value measurement and disclosure requirements in U.S. GAAP would be nearly identical
to those in IFRSs. The proposed ASU would make certain changes to how the fair value measurement
guidance in ASC 820 is applied. Key items within the proposal address the following areas.
Section 3: FASB and IASB Update
60
Highest-and-Best-Use and Valuation-Premise Concepts
The proposed ASU amends the guidance on the highest-and-best-use and valuation-premise concepts by
clarifying that they do not apply to financial assets but only to measuring the fair value of nonfinancial
assets. The boards concluded that financial assets and liabilities “do not have alternative uses,” and thus
the concepts would not apply.
Measuring the Fair Value of Financial Instruments That Are Managed Within a Portfolio
The proposed ASU provides an exception to fair value measurement when a reporting entity holds a group
of financial assets and financial liabilities that have offsetting positions in market risks or counterparty
credit risk that are managed on the basis of its net exposure to either of those risks. That is, when an
entity has a portfolio in which the market risks (e.g., interest rate risk, currency risk, other price risks) being
offset are substantially the same, “the reporting entity shall apply the price within the bid-ask spread that
is most representative of fair value in the circumstances to the reporting entity’s net exposure to those
market risks.”
In addition, when there is a legally enforceable right to offset one or more financial assets and financial
liabilities with a counterparty (e.g., a master netting agreement), “the reporting entity shall include
the effect of the reporting entity’s net exposure to the credit risk of that counterparty in the fair value
measurement.”
The proposal outlines the following criteria an entity must meet to use the exception:
a. Manages the group of financial assets and financial liabilities on the basis of the reporting
entity’s net exposure to a particular market risk (or risks) or to the credit risk of a particular
counterparty in accordance with the reporting entity’s documented risk management or
investment strategy
b. Provides information on that basis about the group of financial assets and financial liabilities to
the reporting entity’s management (for example, the reporting entity’s board of directors or
chief executive officer)
c. Manages the net exposure to a particular market risk (or risks) or to the credit risk of a particular counterparty in a consistent manner from period to period
d. Is required to or has elected to measure the financial assets and financial liabilities at fair value
in the statement of financial position at each reporting date.
Reference Market
The reference market for a fair value measurement is the principal (or, in the absence of a principal,
most advantageous) market, provided that the entity has access to that market. The principal market is
presumed to be the market in which the entity normally transacts. The proposal also indicates that
(1) an entity does not need to perform an exhaustive search for markets that might have more activity
than the market in which the entity normally transacts but (2) the entity should consider information that
is reasonably available.
Application to Liabilities
In the fair value measurement of a liability (whether financial or nonfinancial), it is assumed that the
liability continues and the market participant transferee assumes responsibility for the obligation. The
proposal requires that when using a present value technique to determine the fair value of a liability, a
reporting entity take into consideration the future cash flows that a market participant would require as
Section 3: FASB and IASB Update
61
compensation for taking on and fulfilling the obligation. The guidance also provides examples of how that
compensation may be reflected in the fair value of a liability.
Application to Instruments Classified in Shareholders’ Equity
No guidance currently exists on measuring the fair value of an instrument classified in shareholders’ equity.
The proposed ASU specifies that “the objective of a fair value measurement of an instrument classified in
a reporting entity’s shareholders’ equity . . . is to estimate an exit price from the perspective of a market
participant who holds the instrument as an asset at the measurement date.”
Blockage Factors
The proposal clarifies that the application of a blockage factor is prohibited at all levels of the fair value
hierarchy and notes that a “blockage factor is not relevant and, therefore, shall not be used when fair
value is measured using a valuation technique that does not use a quoted price for the asset or liability
(or similar assets or liabilities).” The boards indicated that the prohibition on using blockage factors is
necessary because blockage is “specific to that reporting entity, not to the asset or liability.” Entities
that currently apply a blockage factor to assets and liabilities categorized within Level 2 of the fair
value hierarchy (that are measured on the basis of quoted prices) could be affected by these proposed
amendments. The Board does not expect other Level 2 and Level 3 fair value measurements to be
affected.
Disclosures
The proposed ASU requires entities to disclose information about measurement uncertainty in the form
of a sensitivity analysis for recurring fair value measurements categorized in Level 3 of the fair value
hierarchy unless another Codification topic specifies that such disclosure is not required (e.g., investments
in unquoted equity instruments are not included in the scope of the disclosure requirement under the
accounting for financial instruments’ EDs). Specifically, the amendment to ASC 820-10-50-2(f) states that
an entity would disclose the following:
A measurement uncertainty analysis for fair value measurements categorized within Level 3 of the
fair value hierarchy. If changing one or more of the unobservable inputs used in a fair value measurement to a different amount that could have reasonably been used in the circumstances would have
resulted in a significantly higher or lower fair value measurement, a reporting entity shall disclose
the effect of using those different amounts and how it calculated that effect. When preparing a
measurement uncertainty analysis, a reporting entity shall not take into account unobservable inputs
that are associated with remote scenarios. A reporting entity shall take into account the effect of
correlation between unobservable inputs if that correlation is relevant when estimating the effect
on the fair value measurement of using those different amounts. For that purpose, significance shall
be judged with respect to earnings (or changes in net assets) and total assets or total liabilities, or,
when changes in fair value are recognized in other comprehensive income, with respect to total equity.
[Emphasis added]
In addition, the proposal:
Section 3: FASB and IASB Update
•
Requires disclosure when “the highest and best use of an asset differs from its current use.”
In this instance, a reporting entity discloses the reason its use of the asset is different from the
highest and best use.
•
Requires disclosure of fair value by level for each class of assets and liabilities not measured at fair
value in the statement of financial position but for which the fair value is disclosed.
62
•
Amends the Level 3 reconciliation requirements. ASU 2010-06 recently amended ASC 820
to require disclosure of significant transfers between Level 1 and Level 2 of the fair value
hierarchy. The proposed ASU amends the disclosure requirement to include any transfers
between Level 1 and Level 2 of the fair value hierarchy.
Effective Date and Transition
The proposed ASU does not yet specify an effective date. The FASB plans to add one after considering the
comments it receives on the proposal. If a change occurs in the fair value measurement of an item as a
result of applying the amendments in the proposed ASU, the transition would be applied via a cumulativeeffect adjustment in beginning retained earnings in the period of adoption. The additional proposed
disclosures would be required prospectively. That is, a reporting entity would provide those disclosures for
periods beginning after the amendments in the proposed ASU are effective.
Current Project Status
The boards are currently jointly deliberating comments received on the proposal and anticipate issuing
final standards during the first quarter of 2011. On the basis of the boards’ decisions, the fair value
measurement and disclosure requirements to be issued under IFRSs are expected to be nearly identical to
those in the proposed ASU, with the following key exceptions (other exceptions may exist):
•
Certain style differences (e.g., differences in spelling and differences in references to other U.S.
GAAP and IFRSs).
•
The assets, liabilities, and equity instruments measured at fair value under IFRSs may differ from
those measured at fair value under U.S. GAAP as a result of the different measurement bases
prescribed by other literature under IFRSs or U.S. GAAP (e.g., currently the measurement bases
for financial instruments are different under IFRSs and U.S. GAAP).
•
Differences in the recognition of day-one gains or losses that arise when the initial fair value of
an asset or liability differs from the transaction price. For example, under IAS 39, gains and losses
related to unobservable market data are precluded from immediate recognition. Under U.S.
GAAP, there is no similar requirement.
•
Differences related to the U.S. GAAP guidance on NAV per share. This guidance provides a
practical expedient that, under certain circumstances, permits an entity to measure the fair value
of investments in certain entities that apply investment-company accounting on the basis of
NAV per share. The IASB is not including this guidance in IFRSs because there are no equivalent
investment-company accounting requirements under IFRSs.
•
Differences in disclosure requirements. For example, IFRSs do not require a reporting entity to
distinguish between recurring and nonrecurring fair value measurements. In addition, amounts
disclosed in Level 3 of the fair value hierarchy may differ because under IFRSs, net presentation
for derivatives generally is not permitted.
Financial Statement Presentation
On July 1, 2010, the FASB and IASB posted to their respective Web sites a staff draft of an ED on financial
statement presentation. The staff draft reflects the boards’ tentative decisions through April 2010. Since
the issuance of the staff draft, the staffs of the FASB and IASB have conducted outreach with financial
statement preparers, financial statement users, and the European Financial Reporting Advisory Group.
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63
At the October 2010 joint board meeting in London, members of both the FASB and IASB expressed
various concerns over the direction of the project. Concerns include the complexity and cost of
implementation as well as questions about first addressing other priorities, such as what is considered
performance (i.e., the conceptual basis of OCI) and when should OCI be recycled. In addition, some board
members felt that an overhaul of the financial statements should only be implemented after the major
projects currently on the boards’ agenda have been fully implemented.
The boards requested that the staff (1) continue with their outreach activities and (2) develop a project
plan that would allow for continuation of discussions after the June 2011 deadline for several other
projects.
Discussion Paper on Effective Dates and Transition Methods
On October 19, 2010, the FASB and IASB issued a discussion paper and a request for views, respectively,
to obtain feedback from their stakeholders on (1) the time and effort they would need to adopt several
new and significant accounting and reporting standards and (2) the dates on which those new standards
should be effective. The documents are not identical; however, both address certain projects that are
being developed jointly by the boards. On the basis of the responses, the FASB and IASB plan to develop
an implementation plan whose main objective will be to help stakeholders properly manage the cost and
pace of these changes.
Scope
The FASB is seeking effective date and transition input on most, but not all, of its current standard-setting
projects. The following projects are within the scope of the discussion paper:
•
Accounting for financial instruments and revisions to the accounting for derivative instruments
and hedging activities (ED issued May 2010).
•
Balance sheet — offsetting (ED expected to be issued during the fourth quarter of 2010).
•
Revenue recognition — revenue from contracts with customers (ED issued June 2010).
•
Leases (ED issued August 2010).
•
Financial statement presentation (timing of the ED is unknown).
•
Discontinued operations (ED expected to be issued during the second quarter of 2011).
•
Financial instruments with characteristics of equity (timing of the ED is unknown).
•
Insurance contracts (discussion paper issued September 2010).
•
Comprehensive income (ED issued May 2010).
Transition Methods
A tentative decision about each of the project’s transition methods has been reached. When determining
whether retrospective or prospective application was the more appropriate method, the FASB weighed
the costs and practicability of applying the standards retrospectively with the benefits of comparability.
Feedback on these methods is being sought for each individual document. The FASB also seeks feedback
on the time and costs of implementing the proposals on the basis of its tentative decisions on transition
methods.
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64
Effective Dates
The effective dates of the projects within the discussion paper’s scope would be either (1) the same date
for all projects (what some have termed the “big bang”) or (2) separate dates for each respective project
(a staggered approach). The FASB has asked stakeholders for input on the two alternatives, including the
perceived advantages and disadvantages of each. Comments on the discussion paper are due by January
31, 2011.
Financial Instruments — Offsetting
The issue of offsetting of financial instruments in the statement of financial position was added to the
financial instruments project during the summer of 2010. This issue is most relevant for the netting of
multiple derivative asset and liability positions between an entity and the same counterparty.
Under IAS 32, to offset a financial asset and financial liability, there must be a legally enforceable right to
set off the two amounts and the intention to settle the positions either on a net basis or simultaneously.
This intention must apply in all circumstances, not just in bankruptcy.
The IASB and FASB have held joint discussions to date on the topic of offsetting. Outreach conducted
with financial statement users indicated that there was no general consensus of views. Credit analysts
would prefer to see both the net (in the statement of financial position) and gross (in footnote disclosure)
exposure for derivatives; however, equity analysts would prefer to have the gross exposures on the face of
the statement of financial position.
The boards have tentatively agreed that offsetting would be required when an entity has the
unconditional right of offset and intends to settle the asset and liability either net or simultaneously (“at
the same moment”). The boards have also tentatively agreed not to permit conditional-right offsetting
such as in the event of bankruptcy with a master netting agreement in place. The tentative decision
is aligned with the current guidance in IAS 32 but would represent a significant change to U.S. GAAP
because under current guidance, the intent to set off does not have to be considered with respect to
derivatives subject to a master netting agreement. As a result, generally fewer derivatives qualify for net
presentation under IFRSs than under U.S. GAAP.
Consolidation
The financial crisis highlighted the potential for entities, often in the financial services industry, to be
exposed to risks not reflected on their balance sheet. Some referred to this off-balance-sheet financing as
a “shadow” banking system. That shadow banking system included an alphabet soup of structures such
as ABS trusts, CDOs, synthetic CDOs, structured investment vehicles (SIVs), CP conduits, and sponsored
money market and hedge funds. Because the financial crisis created enormous stress on the financial
system, many of these off-balance-sheet structures were supported by their financial institution sponsor
either as a result of contractual requirements (e.g., liquidity facilities) or because of the underlying
reputational risk of allowing these structures, and their investors, to fail.
The IASB had been discussing potential changes to its consolidation standards since 2002, but as the
financial crisis deepened, pressure to reassess the consolidation requirements increased, particularly
in connection with the guidance for structured entities under SIC-12. In April 2008, the Financial
Stability Board issued to the G7 Ministers and Central Bank Governors a report recommending the IASB
immediately address the accounting and disclosures for off-balance-sheet arrangements while working
toward global convergence. The G20 leaders then issued a declaration at their November 2008 meeting
that, among other things, called for the improvement of accounting and disclosure standards for
off-balance-sheet vehicles.
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65
Consolidation Proposals
In December 2008, the IASB released ED 10 and, after subsequent deliberations with the FASB, expects
to issue a final standard in the first quarter of 2011. Although the FASB recently issued its own updates to
consolidation accounting for VIEs, the FASB has participated in the IASB’s deliberations and plans to issue
the IASB standard as an ED.
The new consolidation model will focus on a reporting entity’s having control, which is defined as having
the power to direct the activities of another entity to generate returns for the reporting entity. Power
would be the current ability to direct the activities of an entity that significantly affect the returns. The
reporting entity must be exposed to the variability of the entity through upside risk, downside risk, or
both.
Instances in which a reporting entity may have the current ability to direct the activities of another entity
include having:
i.
More than half of the voting rights in an entity controlled by voting rights
ii. Contractual rights within other contractual arrangements that related to the substantive activities of the entity
iii. A combination of contractual rights within other contractual arrangements and holding voting
rights in the entity.
A reporting entity may also direct the activities of another entity by “holding less than half of the voting
rights in an entity considering relevant facts and circumstances.”2
Investment Entity Considerations
The FASB’s subsequent deliberations have also focused on consolidation considerations of investment
entities. Unlike U.S. GAAP, under which investment companies are exempt from applying consolidation
accounting to their funds’ investments (unless those investments are also investment companies), there
is currently no similar scope exception under IFRSs. The FASB is expected to issue an ED in the second
quarter of 2011 to exempt investment entities from consolidation when they meet certain criteria related
to their:
•
Business purpose.
•
Investment activity.
•
Exit strategy.
•
Unit ownership.
•
Pooling of funds.
•
Use of fair value for reporting purposes.
The original decisions of both boards was that the fair value accounting at the investment company
level would not be retained at the investment manager level unless that manager is also an investment
company. Therefore, an investment manager would consolidate all controlled investees, including those
A reporting entity that holds less than half of the voting rights in an entity may need to rely on other indicators of power, such as whether it can
obtain additional voting rights from holding potential voting rights, whether the entity’s operations are dependent on the reporting entity, or the size
of their voting rights relative to that of any other voting rights holder. Potential voting rights such as options and convertible instruments should be
considered when assessing whether a reporting entity has the power to direct the activities of an entity.
2
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66
held by investment company subsidiaries. However, the FASB recently reversed its previous decision and
will now permit the retention of fair value accounting at the parent level. The boards have not discussed
the issue since the FASB’s decision, so it remains to be seen whether the IASB will follow suit or whether
there will continue to be divergence in this area under U.S. GAAP and IFRSs.
Disclosures
Along with the consolidation standard, the IASB also expects to issue an IFRS related to disclosures
for subsidiaries, joint ventures, associates, and unconsolidated structured entities in the fourth quarter
of 2010. A reporting entity will be required to provide information about (1) its involvements with
unconsolidated structured entities and (2) structured entities in which the reporting entity is the sponsor
but no longer has an involvement as of the reporting date. In addition, for consolidated entities with
NCIs, additional disclosure will be required, including the name of the subsidiary, the subsidiary location
of incorporation or residence, the method for allocating profits and losses to the NCI (and if not on a pro
rata ownership basis, the portion of voting rights held by the NCI), and summarized financial information
for the subsidiary.
IFRS Update
Amendments to IFRS 9 Related to Accounting for Financial Liabilities
Classification and measurement of financial assets was the first phase of the project to reform the
accounting for financial instruments to be finalized, resulting in the issuance of IFRS 9 in November
2009. That project originally included classification and measurement of financial liabilities; however,
because of the accelerated time frame of the project and contention over the measurement of some
financial liabilities at fair value, liability measurement was separated into its own project. The IASB recently
completed the second phase, measurement of financial liabilities, resulting in amendments to IFRS 9 in
October 2010. The guidance within the amendments to IFRS 9 on accounting for financial liabilities is
similar to the guidance previously held in IAS 39 except for the two notable exceptions discussed below.
Removal of Cost Exception for Unquoted Derivative Instruments
The initial version of IFRS 9 removed the cost exception in IAS 39 for unquoted equity instruments
and related derivative assets when fair value was not reliably determinable. These amendments to
IFRS 9 removed that exception for derivative liabilities so they too would no longer be eligible for cost
measurement and would be measured at fair value.
Separation of Credit Risk
As the term implies, in a liability designated under IAS 39 as “at fair value through profit or loss,” the
entire change in fair value of the liability is recognized in profit and loss. However, the amendments
to IFRS 9 provide a significant change in presentation of such a liability. Under these amendments, the
amount of change in a liability’s fair value attributable to changes in the credit risk of the liability would
be recognized in OCI, with the remaining amount of change in fair value recognized in profit and loss.
The amount of credit losses recognized in OCI would not be recycled to profit and loss, even if the liability
were settled at fair value (i.e., an amount less than the outstanding principal balance).
However, if recognizing the change in fair value attributable to credit risk within OCI would create or
exacerbate an accounting mismatch, an entity would then present the entire change in fair value within
profit and loss. The determination of whether an accounting mismatch exists is made at initial recognition
of the liability and is not reassessed.
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The guidance related to identifying credit risk as part of measuring liabilities at fair value through profit
or loss differentiates credit risk from asset risk (the risk that a single asset or a group of assets will not
perform sufficiently) and provides examples of asset risk. One of the examples of asset risk provided in
the standard is that of an SPE, for example, an ABS trust or a CDO structure. The assets of the SPE are
legally isolated to fund the debt securities issued by the vehicle. If the assets do not generate sufficient
cash flows, the security holders begin absorbing losses based on their level of seniority within the waterfall
of the tranched securities. Entities consolidating SPEs would not be required to identify the accounting
mismatch because the changes in fair value of the outstanding notes would be attributable to items other
than credit risk (e.g., asset risk, interest rate risk, liquidity risk).
The amendments also provide guidance on isolating the change in fair value of a liability attributable to
credit risk as either (1) the change in fair value not attributable to changes in market risk (i.e., changes in
a benchmark interest rate, the price of another entity’s financial instruments, a commodity price, a foreign
exchange rate, or an index of prices or rates) or (2) an alternative method that more faithfully represents
credit risk. When the only significant changes in market conditions are changes in an observable
benchmark interest rate, the amendments also provide specific guidance on how to measure the credit
risk.
The amendments also include new disclosure requirements for financial liabilities under IFRS 7. Those
disclosure requirements include:
•
The cumulative amount of change in the fair value of a liability attributable to changes in credit
risk.
•
The difference between the carrying amount of the liability and the contractual obligation at
maturity.
•
During the current period, any transfers of the cumulative gains or losses within equity and the
reason for the transfer.
Effective Date and Transition
The effective-date guidance related to these amendments follows the same approach within IFRS 9
(e.g., early adoption would be permitted but also must be applied to all other finalized requirements in
IFRS 9 previously issued). The IASB also decided to require (1) retroactive application of the requirements
and (2) that the determination of whether an accounting mismatch exists be based on the facts and
circumstances that exist as of the date of the amendments’ initial application.
Amendments to Derecognition Disclosures Under IFRS 7
The derecognition project was originally added to the IASB’s agenda in July 2008 in response to (1)
the then ongoing financial crisis and (2) issues that resulted from the transfer of assets from financial
institutions’ balance sheets while the institutions maintained various forms of continuing involvement with
such assets. Although derecognition was intended to be a convergence project, the SEC requested that
the FASB follow an accelerated timetable to amend its own derecognition requirements.
In April 2009, the IASB published ED/2009/3, which proposed (1) a new derecognition model and (2)
an alternative model, both based on control of the transferred assets. However, the responses to the ED
largely opposed use of the proposed model. In June 2010, the IASB reprioritized its work plan, which
included delaying the derecognition project indefinitely.
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Instead, the board shifted its focus to increasing the level of transparency and comparability in disclosures
of financial asset transfers. In October 2010, the IASB issued amendments to IFRS 7 that increase
the disclosure requirements for transactions involving financial asset transfers by providing greater
transparency about risk exposures of transactions in which a financial asset is transferred but the transferor
retains some level of continuing involvement in the asset.
The amendments clarify that the disclosure requirements apply to transfers of all or part of a financial
asset if the entity:
(a) [T]ransfers the contractual rights to receive the cash flows of that financial asset; or
(b) [R]etains the contractual rights to receive the cash flows of that financial asset, but assumes a
contractual obligation to pay the cash flows to [other recipients] in an arrangement.
An entity has continuing involvement in a transferred financial asset if it “retains any of the contractual
rights or obligations inherent in the transferred financial asset or obtains any new contractual rights or
obligations relating to the transferred financial asset.”
For transfers of financial assets that do not qualify for derecognition, an entity must disclose information
that will enable users to understand the relationship between transferred financial assets that are not
derecognized in their entirety and the associated liabilities. For each class of financial asset, the entity is
required to disclose:
(a) [T]he nature of the transferred assets.
(b) [T]he nature of the risks and rewards of ownership to which the entity is exposed.
(c) [A] description of the nature of the relationship between the transferred assets and the associated liabilities, including restrictions arising from the transfer on the reporting entity’s use of
the transferred assets.
(d) [W]hen the counterparty (counterparties) to the associated liabilities has (have) recourse only
to the transferred assets, a schedule that sets out the fair value of the transferred assets, the
fair value of the associated liabilities and the net position.
(e) [W]hen the entity continues to recognise all of the transferred assets, the carrying amounts of
the transferred assets and the associated liabilities.
(f) [W]hen the entity continues to recognise the assets to the extent of its continuing involvement
. . . the total carrying amount of the original assets before the transfer, the carrying amount of
the assets that the entity continues to recognise, and the carrying amount of the associated
liabilities.
For financial asset transfers that result in full derecognition with the entity’s continuing involvement in the
assets, the entity must disclose information that allows users to evaluate both the nature of and the risks
associated with the entity’s continuing involvement in derecognized financial assets. An entity is required
to disclose information at the reporting date for each class of continuing involvement, including:
Section 3: FASB and IASB Update
•
The carrying amounts and fair values of the assets and liabilities that represent the entity’s
continuing involvement in the derecognized financial assets.
•
The maximum exposure to loss from the entity’s continuing involvement.
•
The undiscounted cash flows that are or may be required to repurchase derecognized financial
assets, along with a maturity analysis of those cash flows.
•
Any gain or loss recognized at the date of the asset transfer.
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•
Any income and expenses recognized in the reporting period from the entity’s continuing
involvement in the derecognized financial assets.
•
Qualitative information to support and explain the quantitative disclosures.
The disclosures would be applied prospectively for annual periods beginning on or after July 1, 2011.
The most notable difference in the disclosure requirements accepted by the IASB and those required
by U.S. GAAP relates to the servicing of assets and liabilities. Because IAS 39 does not contain specific
guidance on the subsequent accounting for these items, the IASB agreed that rather than include
disclosure requirements for the servicing of assets and liabilities within the scope of IFRS 7, any disclosures
should be regarded as part of a broader consideration of the topic.
IASB Pending Projects
Financial Instruments — Amortized Cost and Impairment
In 2009, the IASB issued an ED on its amortized cost and impairment proposals. The comment period for
those proposals closed in June 2010, and the IASB is currently weighing the concerns expressed through
comment letter responses as well as the input provided by the Expert Advisory Panel (EAP), a group
supporting the IASB by providing insight on operational challenges preparers may face in implementing
the proposals. The Board is involved in subsequent deliberations based on the feedback it has received;
it has suggested a potential for reexposure early in the first quarter of 2011. A summary of the original
proposals and the subsequent decisions to date are detailed below.
ED Proposals
The IASB proposals introduce an expected-loss model for amortized cost measurement and income
recognition, a significant change from the incurred-loss model for impairments currently used in practice.
At the initial recognition of a financial instrument measured at amortized cost, an entity would determine
its estimate of expected future cash flows incorporating the potential for credit losses, i.e., nonpayment
by the borrower, using a probability-weighted expected outcome approach. Instead of recognizing credit
losses if and when they are incurred (as under the current accounting model), the future credit losses
expected on the date the asset is initially recognized would be incorporated into the measurement of the
asset by recognizing a lower EIR over the life of the instrument than the contractual EIR. The effective
return on the instrument would incorporate any fees, points, or transaction costs; any premium or
discount on the acquisition; and the initial estimate of expected credit losses. An allowance will be built
over the life of the instrument calculated as the periodic portion of expected credit losses included as part
of the EIR.
If the losses expected after the asset was initially recognized are different in timing and/or amount than
they were when the asset was first recognized, an adjustment to the carrying amount of the financial
asset is made immediately and is recognized directly in profit and loss. If the timing and amount of actual
losses equal those that were originally expected when the asset was initially recognized, the allowance
built up over the life of the instrument will equal the actual losses suffered as a result of nonpayment by
the borrower. An entity would establish a policy for identifying uncollectible amounts and determining
when the allowance account would be used for writing off the asset.
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The following table summarizes the key concepts of the IASB proposals.
Initial Recognition:
Estimate Future
Credit Losses
Over Life of Asset
• Asset by asset or
groups of similar
assets.
• Estimate expected
cash flows taking
into account
expected future
credit losses over the
life of the asset or
assets.
• Probability-weighted
possible outcome
approach even if
most likely outcome
is full repayment.
• No up-front loss is
recognized — credit
loss estimate impacts
net interest revenue
over time.
Net Interest
Revenue Adjusted
for Margin to
Reflect Initial
Estimate of Future
Credit Losses
• Margin for initially
expected credit
losses is deducted
from gross interest
revenue in each
period.
• Determined through
application of the EIR
method.
• Practical expedients
permitted if they
meet certain criteria.
Allowance for
Future Credit
Losses Built Up
Over Time
• The margin for
initially expected
credit losses that
is deducted from
gross interest
revenue in each
period is set aside
to gradually build
up an allowance
for expected future
credit losses.
• Applies even if no
actual losses have yet
been incurred.
• Does not require
objective evidence
of impairment or
loss events to have
occurred.
Ongoing
Adjustments to
Estimates of
Future Credit
Losses
• In each period,
the entity must
reassess the asset’s
expected cash flows,
taking into account
expected future cash
flows.
• Any changes in credit
loss expectations
— both favorable
and unfavorable
— are recognized
immediately on a
discounted cash flow
basis as a gain or loss
in earnings.
• Discount revised
expected future cash
flows at the asset’s
EIR.
Example Illustration
In the following example, a fairly simple transaction is used to illustrate these concepts. Assume that Bank
A has a cost of funding of four percent and originates a loan of $100,000, and the loan terms require
a single payment from the borrower of $110,000 one year from origination (a coupon interest rate of
10 percent). On the basis of its experience with similar loan originations, Bank A anticipates there is a
97.5 percent likelihood that the borrower will fulfill its obligation to pay the loan in full. However, there
is a 2.5 percent likelihood the borrower will default on the loan and not be able to make the scheduled
repayment. Using the probability-weighted outcomes, the lender anticipates receiving $107,250
($110,000 at 97.5 percent confidence and $0 at 2.5 percent confidence).
In this example, the EIR used to accrue net interest revenue is 7.25 percent (the one-year anticipated
return on the $100,000 loan) compared with the contractual EIR under an incurred-loss model of 10
percent. The IASB’s view is that recognizing the 10 percent interest over the life of the loan would
overstate net interest revenue because Bank A only anticipates receiving a net 7.25 percent return when
taking into account expected credit losses. In other words, recognizing the 10 percent interest frontloads
interest revenue early in the life of the loan until expected future losses are incurred.
Instead, under the IASB’s proposal, the expected future losses are set aside throughout the life of the loan
as a loan loss allowance. Proponents of the IASB’s approach believe this better reflects how entities make
lending decisions and price loans, including compensation for additional assumption of credit risk.
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71
So what do the accounting entries look like for this transaction?
Loan Origination
Debit
Loan receivable
Credit
$ 100,000
Cash
$ 100,000
Interest Recognition (shown as one annual entry rather than 12 separate monthly entries)
Debit
Interest receivable
Credit
$ 10,000
Interest revenue
$
7,250
Loan receivable — allowance for credit losses
2,750
At the end of the year, three scenarios are possible:
•
Scenario 1, actual credit losses match the initial expectation of credit loss estimates — Assume
that the actual credit losses are $2,750 and no gain or loss is recognized at the end of the year.
Bank A would write off the part of the interest receivable that is uncollectible ($2,750) against
the allowance account.
•
Scenario 2, actual credit losses are zero or lower than the initial expectation of credit loss
estimates — Assume that the entire $110,000 is collected, contrary to the initial expectation of
$107,250. In this case, Bank A would record a gain of $2,750 at the end of the year to reverse
the allowance for credit losses of $2,750 established throughout the year.
•
Scenario 3, actual credit losses exceed the initial expectation of credit loss estimates — Assume
that the borrower defaults on the loan and Bank A receives no repayment of the $100,000 loan
receivable. In this instance, Bank A would change its estimate of future expected cash flows and
would adjust the carrying amount of the loan receivable to $0 by recognizing an impairment loss
on the $100,000 plus the accrued interest revenue of $7,250.
The proposal also details specific presentation requirements for profit and loss as follows:
Statement of Profit and Loss Presentation
Scenario 1
Scenario 2
Scenario 3
Gross interest revenue
$
10,000
$
10,000
$
10,000
Periodic portion of initial estimated credit losses
(2,750)
(2,750)
(2,750)
Net interest revenue
7,250
7,250
7,250
Interest expense
4,000
4,000
4,000
Net interest margin
3,250
3,250
3,250
Changes in estimates of expected credit losses
—
2,750
(107,250)
Net income
$
$
6,000
$ (104,000)
3
3,250
Net interest margin is not specifically required in the proposal. However, most financial institutions will include it in a separate line because it is a key
performance indicator for those entities.
3
Section 3: FASB and IASB Update
72
Operational Concerns of Proposals
The EAP and many comment letter respondents expressed significant concerns regarding the
operationality of the expected cash flow impairment model. The application of this model to an open
portfolio of assets, into and out of which assets may be continuously moving, is not thought to be
possible. The problem focuses on (1) isolating the initial assets and the estimate of expected credit losses
for those assets and (2) identifying subsequent revisions to expected future cash flows attributable to the
original assets compared with those assets subsequently added to the portfolio. Another concern that
many preparers expressed is the technological challenge, since the information necessary to develop the
expectation of future credit losses is typically housed in a separate credit-risk system other than that used
for financial reporting. A potential solution suggested by the EAP is to “decouple” or separately source the
information from the accounting and risk management systems. This could be accomplished by adjusting
the interest revenue amounts calculated from the accounting system with an allocation method for
expected credit losses derived from information in the risk management system. In practice, entities will
have many financial assets subject to impairment with different contractual terms and differing degrees of
credit risk; performing an expected-loss assessment at initial recognition thereafter will prove challenging.
Proposed Disclosures
The ED also proposes several disclosure requirements, including grouping of disclosures into classes of
instruments and vintage information such as year of origination and scheduled maturity. The disclosures
also require an entity to provide a reconciliation of changes in the allowance account, a description of
its write-off policy, and information about the use of estimates and changes in estimates — including
inputs and assumptions used in the determination of expected credit losses and explanations for amounts
recognized in profit and loss resulting from changes in estimates of credit losses. In addition, if an entity
uses stress testing as part of its risk management process, information about such stress tests should be
disclosed. Detailed information regarding nonperforming assets is also required as part of the proposal.
Several comment letter respondents to the ED expressed concern over certain aspects of the proposed
disclosures, including sensitivity analysis, loss triangles, stress testing, nonperforming assets, and vintage
information. Those concerns include the operational burden on preparers created by requiring such
disclosures and questions on how useful the information will be to investors.
Effective Date and Transition
The proposed amendments will be included as part of IFRS 9 with early application provisions available.
However, if an entity elects to early adopt any part of the IFRS 9 amendments, it must also apply any
other provisions of IFRS 9 that are already finalized and not currently applied. According to the proposed
transition requirements, for those items recognized before the effective date, an entity must adjust the
EIR to approximate the rate that would have been applied had the standard been in effect at that time.
However, comment letter respondents have expressed concern about the proposed transition provision
and its application to existing financial assets measured at amortized cost. Their concern focuses on (1) the
ability to go back to a historical point in time to develop estimates that were not originally made, solely
to recalculate an EIR for application purposes, and (2) whether this recalculation provides information
relevant to investors.
Subsequent Deliberations
The IASB is currently redeliberating the proposals in light of the feedback received. To date, the Board
has tentatively agreed to continue pursuing an expected-loss model that will use all available information
in the estimate to forecast losses over the life of the financial asset. The Board has also reaffirmed its
previous decision to spread those initial loss estimates over the life of the instrument. Perhaps most
Section 3: FASB and IASB Update
73
important, the Board has tentatively agreed to permit the use of a “decoupled EIR” (separately sourcing
the EIR and expected credit losses) to address the operational concerns expressed by comment letter
respondents and the EAP.
The Board has also begun discussions on a “good book/bad book” approach; items within the “good
book” would follow the model described above. However, once an item has been transferred to the “bad
book,” the expected loss would be fully recognized immediately. The Board has tentatively decided not to
specifically require when items should be transferred to the “bad book” (e.g., more than 90 days past due)
but instead to have entities follow their process for managing credit risk and nonperforming assets.
The Board has also begun discussions on a “good book/bad book” approach; items within the “good
book” would follow the model described above. However, once an item has been transferred to the “bad
book,” the expected loss would be fully recognized immediately. The most significant sources of tension in
these discussions will most likely be (1) how the IASB defines the criteria for items being transferred to the
bad book and (2) whether that approach either follows an entity’s risk management process or specific
“brightlines” are mandated (e.g., more than 90 days outstanding).
Financial Instruments — Hedge Accounting
IASB constituents have criticized the hedging model in IAS 39 for being overly complex and rules-based.
They requested that any revisions to the hedge accounting model (1) be more principles based and (2)
make hedge accounting more available when the activity is consistent with risk management activities.
They also expressed support for a complete reconsideration of hedge accounting rather than a piecemeal
alteration of the current model to address certain application issues.
IASB outreach with financial statement users has consistently raised comments about the hedge
accounting model not being appropriately linked to an entity’s risk management processes. As a result,
a continuing theme throughout this project has been better integration of risk management and hedge
accounting.
Discussions on phase one of the hedge accounting project have been ongoing throughout 2010, and
the IASB completed those discussions at the end of October. An ED was issued in early December with a
90-day comment period.
Scope
The Board agreed to permit a designation of risk components approach to hedge accounting for both
financial and nonfinancial instruments in which the risk component can be separately identifiable and
reliably measurable. For example, an entity can apply hedge accounting to only the interest rate risk
of a variable rate corporate bond denominated in a foreign currency and not to all associated risks
(e.g., interest rate risk, credit risk, and foreign exchange risk). This is important because it (1) ensures a
greater alignment of the derivative used to hedge the specific risk with the hedge designation for hedge
accounting and (2) limits the “noise” associated with hedge ineffectiveness.
IFRS 9 eliminated the concept of bifurcating embedded derivatives in hybrid financial assets. The IASB
considered how this may affect hedge accounting since those derivatives embedded in hybrid financial
assets would no longer be considered separate financial instruments. The Board decided not to permit
those derivatives to be eligible hedging instruments.
Section 3: FASB and IASB Update
74
Fair Value Hedge Accounting
The Board agreed that the ineffective portion of the fair value hedging relationship will be recognized
in profit or loss while the effective portion would be recognized in OCI (offsetting to zero). However,
contrary to IAS 39, they agreed on the creation of a “separate account” valuation allowance within either
assets or liabilities rather than remeasuring the hedged item for changes in value associated with the
hedged risk.
Hedge Effectiveness Assessment
The Board also agreed to replace the quantitative-based hedge effectiveness measurement (the arbitrary
80 percent to 125 percent effectiveness test) to initially qualify and continually retain hedge accounting.
Instead, the Board tentatively agreed on a framework for hedge effectiveness qualification that requires (1)
the hedging relationship to be unbiased and to minimize ineffectiveness (i.e., not intentionally overhedged
or underhedged) and (2) the level of offset to be more than accidental.
The Board is also permitting voluntary rebalancing of the hedging relationship to retain hedge accounting
under the hedge effectiveness criteria as long as the risk management strategy has not changed.
Hedging of Groups of Items
The Board has also decided to permit hedge accounting of net positions for fair value hedges and certain
cash flow hedges. Cash flow hedges would be restricted from net position hedging if the highly probable
forecast transaction would affect profit or loss in different periods.
Time Value of Options
If an entity designates a derivative that is an option (e.g., a purchased call option or interest rate cap),
under IAS 39, it is required to designate the hedging instrument in its entirety or just the intrinsic value
of the option. Because the option is only regarded as offsetting the risk exposure of the hedged item
when it is in-the-money, the designation of the option in its entirety generally results in significant hedge
ineffectiveness due to the fair value changes of the option associated with its time value. In practice,
therefore, entities only designate the intrinsic value of the option, which results in immediate recognition
in profit or loss of the fair value movements associated with time value. Some regard this profit or loss
volatility as artificial and have long sought a solution to overcome this.
In response, the Board has agreed on an “insurance premium view” of accounting for the time value
associated with options. Under the insurance premium view, for transaction-related hedged items (e.g.,
forecast purchase of a commodity), the cumulative change in the fair value of the option attributable to
time value would be recognized in OCI and then recycled (i.e., a nonfinancial asset would be capitalized,
hedged sales would be recycled into profit or loss). Likewise, for time-related hedged items (e.g., hedging
existing commodity inventory over a specified period), the cumulative change in the fair value of the
option attributable to time value would be recognized in OCI and amortized to profit or loss as insurance
premiums paid on a rational basis. To avoid accounting issues associated with option terms that do not
match the hedged items, if the actual time value is less than the time value of an option that perfectly
matches the hedged item, the amount recognized in accumulated OCI would be determined to be the
lower of (1) the fair value change of the actual time value and (2) the time value of the “perfect” option.
Those amounts in OCI would also be subject to an impairment test.
Section 3: FASB and IASB Update
75
Presentation and Disclosure
Aside from the change in presentation associated with fair value hedges described above, the Board
has addressed two other presentation issues related to hedge accounting. The first presentation issue
relates to applying hedge accounting to the foreign exchange risk of a firm commitment. IAS 39 currently
allows for designation of these relationships as either a fair value hedge or a cash flow hedge because
of the impact to both the cash flows and the fair value of the firm commitment. The Board tentatively
agreed to retain this designation choice on a hedge-by-hedge relationship. The second presentation issue
relates to applying cash flow hedge accounting to a forecast transaction, which results in recognition of
a nonfinancial item. IAS 39 currently permits an accounting policy election of either adjusting the initial
basis of the recognized nonfinancial item for gains and losses to date on the hedging instrument or
retaining those gains or losses in OCI. To address the lack of comparability resulting from the accounting
policy choice, the Board has proposed requiring adjustment of the initial basis when the non-financial
forecast transaction occurs by directly adjusting accumulated OCI (thereby not affecting the performance
statement upon adjustment).
The Board has also developed a disclosure framework for hedging activities. The proposed disclosures
include requiring a tabular format presentation of information by type of hedge and by risk category
for the effects of hedge accounting on the statement of financial position, the statement of profit and
loss, the statement of OCI, and the cash flow hedge reserve. Information about hedge accounting
not captured in the financial statements will also be required, including the risk management strategy,
quantitative information of risk exposures and how the risk is hedged (including the monetary amount of
quantity, e.g., barrels, tons), exposure for that risk, the monetary amount of quantity of the risk exposure
being hedged, and how hedging has changed the exposure.
Section 3: FASB and IASB Update
76
Section 4
Asset Management Sector Supplement
Asset Management Accounting Update
This section discusses recent accounting developments that are of specific interest to the asset
management sector. It should be read in conjunction with Sections 1 and 2, which address other key
accounting considerations that apply more broadly to financial services entities and may be relevant to the
asset management sector.
ASU 2010-06
On January 21, 2010, the FASB issued ASU 2010-06. The ASU amends ASC 820 to add new requirements
for (1) disclosures about transfers into and out of Levels 1 and 2 and (2) separate disclosures about
purchases, sales, issuances, and settlements related to Level 3 measurements. It also clarifies existing fair
value disclosures about the level of disaggregation and about inputs and valuation techniques used to
measure fair value.
Although it had been proposed in the ED, entities are not required to provide sensitivity disclosures under
the ASU. However, the FASB and IASB are jointly considering whether to require sensitivity disclosures as
part of their convergence project on fair value measurement. The FASB issued an ED on the topic in June
2010, and a final standard is expected in the first quarter of 2011.
The guidance in ASU 2010-06 is effective for the first reporting period (including interim periods)
beginning after December 15, 2009, except for the requirement to provide the Level 3 activity of
purchases, sales, issuances, and settlements on a gross basis, which will be effective for fiscal years
beginning after December 15, 2010, and for interim periods within those fiscal years. In the period of
initial adoption, entities will not be required to provide the amended disclosures for any previous periods
presented for comparative purposes. However, those disclosures are required for interim and year-end
periods ending after initial adoption. Early adoption is permitted.
See Section 1 for further details.
ASC 810
In January 2010, the FASB issued ASU 2010-10. The ASU defers the application of Statement 167 for a
reporting enterprise’s interest in certain entities that have all the attributes of an investment company or
for which it is industry practice to apply measurement principles for financial reporting that are consistent
with those followed by investment companies. The deferral also applies to a reporting entity’s interest in
an entity that is required to comply or operate in accordance with requirements similar to those in Rule
2a-7 of the Investment Company Act of 1940 (the “Investment Company Act”) for registered money
market funds. The deferral does not apply to situations in which a reporting entity has the explicit or
implicit obligation to fund losses of an entity that could potentially be significant to the entity and to
interests in securitization entities, asset-backed financing entities, or entities formerly considered QSPEs.
Any entities qualifying for the deferral will continue to be assessed under the overall guidance on the
consolidation of VIEs in ASC 810-10 before it was updated by Statement 167.
The ASU’s amendments also clarify that for entities that do not qualify for the deferral, related parties
should be considered when an entity evaluates whether the fee of a decision maker or service provider
represents a variable interest. In addition, the requirements for evaluating whether such fee is a variable
interest are modified to clarify the FASB’s intention that a quantitative calculation should not be the sole
basis for this evaluation.
The ASU is effective for all reporting periods beginning after November 15, 2009.
Section 4: Asset Management Sector Supplement
77
As a result of the deferral, asset managers must consider their involvement with securitization vehicles
(e.g., CDOs), asset-backed funding facilities, or certain entities for which they have provided a guarantee
and that are not similar in nature to money market funds. They must then evaluate whether they have
the power to direct the economic activities of those structures and whether the fee received from those
structures could be potentially significant to the VIE. If so, the asset manager would most likely be
considered the primary beneficiary and will be required to consolidate the VIE.
TPA on Alternative Investments
The AICPA Investment Companies Expert Panel and Staff issued guidance on December 23, 2009, in
the form of Technical Practice Aids (TPAs) to assist entities in valuing their investments in nonregistered
investment companies, such as hedge funds, private equity funds, real estate funds, commodity funds,
and common/collective trust funds (individually and collectively, alternative investments). The guidance
is intended to help entities value such investments in accordance with the provisions of ASC 820 as
amended by ASU 2009-12. ASU 2009-12 allows investors to value alternative investments by using the
NAV per share calculated by the manager of the investment company or its administrator as a practical
expedient to determining an independent fair value. ASU 2009-12 limited when the practical expedient
could be used and provided guidance on applying the fair value hierarchy that was part of Statement
157 (now encompassed in ASC 820). The TPA is set out in AICPA Technical Questions and Answers (TIS)
Sections 2220.18–.27, which apply to investments that are required to be measured and reported at
fair value and are within the scope of ASC 820-10-15-4 and 15-5. The TPA’s guidance in those sections
consists of the following topics:
•
Applicability of Practical Expedient (TIS Section 2220.18).
•
Unit of Account (TIS Section 2220.19).
•
Determining Whether NAV Is Calculated Consistent With FASB ASC 946, Financial Services —
Investment Companies (TIS Section 2220.20).
•
Determining Whether an Adjustment to NAV Is Necessary (TIS Section 2220.21).
•
Adjusting NAV When It Is Not as of the Reporting Entity’s Measurement Date (TIS Section
2220.22).
•
Adjusting NAV When It Is Not Calculated Consistent With FASB ASC 946 (TIS Section 2220.23).
•
Disclosures — Ability to Redeem Versus Actual Redemption Request (TIS Section 2220.24).
•
Impact of “Near Term” on Classification Within the Fair Value Hierarchy (TIS Section 2220.25).
•
Categorization of Investments for Disclosure Purposes (TIS Section 2220.26).
•
Determining Fair Value of Investments When the Practical Expedient Is Not Used or Is Not
Available (TIS Section 2220.27).
Although the TPA is nonauthoritative, entities may still find it helpful in applying and adopting the existing
accounting pronouncements issued by the FASB.
Section 4: Asset Management Sector Supplement
78
Using NAV as a Practical Expedient
ASU 2009-12 notes that NAV may only be used as a practical expedient of fair value if:
• The investee has calculated NAV in a manner consistent with ASC 946, which contains guidance
on how investment companies calculate NAV under U.S. GAAP.
•
The NAV has been calculated as of the investor’s measurement date (e.g., date of the financial
statements).
•
It is not probable as of the measurement date that the reporting entity will sell a portion of an
investment at an amount different from NAV.
If any of these criteria are not met, the entity should consider an adjustment to the NAV.
The TPA suggests that the reporting entity’s management should independently evaluate the fair value
measurement process used by the alternative investment manager in calculating NAV to determine
consistency with ASC 946. Many investors already consider this to be part of their initial and ongoing
due diligence process. The TPA focuses on the need to evaluate the adequacy of the financial reporting
processes and controls used to estimate fair value that exist at the underlying fund manager (or its
administrator) and suggests that investors should understand and evaluate changes in such processes
and controls. It provides specific points that investors may want to address and document, including the
following:
•
The portion of the underlying securities held by the investee fund that are traded on active
markets.
•
The professional reputation and standing of the investee fund’s auditor and any qualification of
its report.
•
Whether there is a history of significant adjustments to the NAV reported by the investee fund
manager as a result of the annual financial statement audit or otherwise.
•
Findings in the investee fund’s adviser or administrator’s SAS 70 report, if any.
•
Whether NAV has been appropriately adjusted for items such as carried interest and clawbacks.
•
Comparison of historical realizations to last reported fair value.
The TPA notes that an investor in a fund of funds should evaluate the controls and processes at the fund
of funds manager and would not necessarily be required to look through to the processes and controls at
the underlying fund interests of the fund of funds.
Considerations When the NAV Is Not Used
When the practical expedient is not available or when an entity elects not to use it, an entity will need to
estimate the fair value of the alternative investment. When the NAV is of a date other than the entity’s
measurement date, the TPA suggests that an entity perform a rollforward from the date of the NAV that
takes into account capital activity and changes in valuations.
The TPA notes that, in some instances, an entity may be able to obtain sufficient information from the
alternative investment manager to estimate an adjustment to a provided NAV that was not in accordance
with U.S. GAAP. However, depending on the availability of valuation information, transparency, and
Section 4: Asset Management Sector Supplement
79
unique characteristics of the alternative investments, the task of determining the fair value of such
investments may pose challenges, and significant effort will most likely be required in the estimation of fair
value for these alternative investments that do not have readily determinable fair values.
The TPA offers examples of inputs that might be used in an entity’s estimation and adjustment of fair
values and reminds entities that methods used to measure the fair value of an investment should reflect
assumptions that a market participant would use to value the asset on the basis of the best information
available. Example inputs include NAV; observed transactions, including level and volume of activity;
expected future cash flows; features of the alternative investment and its investment performance
relative to benchmarks/indices; and other comparable investments. Each individual feature would need
to be assessed for its potential impact on fair value. The AICPA’s inclusion of these considerations in
the TPA suggests that demand for an alternative investment may be higher (or lower) than comparable
investments because certain elements are more (or less) attractive than those on comparable investments
and therefore an investor would be willing to pay more (or less) than the NAV of such an alternative
investment. The TPA notes that after evaluating these elements, an entity may conclude that the NAV is
the best measure of fair value.
In evaluating features, entities should, according to the TPA, distinguish between (1) initial due diligence
features, which are features inherent to the specific alternative investment (such as restrictions on
redemption outlined in the offering memorandum) that were contemplated (and accepted) when the
initial investment was made and (2) ongoing monitoring features, which are features related to activities
after the initial investment, including the triggering of key provisions in the governing documents.
The presence of initial due diligence features by themselves may not require an adjustment to NAV
because they (1) may represent common features of similar investment products offered in the
marketplace, (2) have been accepted by investors at the initial acquisition as not being a significant
deterrent or adjustment factor to initial NAV, or (3) both. For example, the presence of gate provisions,
or the contractually allowable use by the alternative investment manager of side pockets, may not have
any impact on NAV over the holding period unless those provisions are exercised by the manager. The
reporting entity should also consider key initial due diligence features in the alternative investment relative
to those prevailing in the current market; terms that are more restrictive than those observed in the
marketplace for similar alternative investments may suggest a discount and vice versa.
In contrast, ongoing monitoring features, which cause a significant change in conditions relative to those
on the initial due diligence date, are more likely to result in fair value adjustments. To illustrate, the actual
imposition of a gate provision may be indicative of liquidity concerns with the underlying investments and
also result in liquidity concerns with respect to alternative investment as a whole because a gate provision
is likely to increase the timing of redemption receipt. Such features are those a market participant is likely
to consider and may result in a discount to the investment value. The magnitude of the discount is a
matter of professional judgment. In general, an investor should evaluate how changes from the initial due
diligence features may affect an alternative investment’s fair value when an entity is not using or is not
able to use NAV as a practical expedient.
Disclosures
ASU 2009-12 suggests that if the reporting entity does not have the ability to redeem its investment at
NAV (e.g., it has the contractual and practical ability to redeem) in the “near term” on the measurement
date, the investment should be classified as Level 3 in the fair value hierarchy. The TPA clarifies two points:
1. For an investment in a redeemable alternative investment to meet the criteria for Level 2
classification in the fair value hierarchy, the reporting entity need not have submitted a previous
redemption request effective as of the measurement date.
Section 4: Asset Management Sector Supplement
80
2. A redemption period of 90 days or less would generally be considered “near term,” although
other factors may be relevant and should be considered.
The fair value hierarchy is required to be shown for major categories of investments, and investors have
questioned how that should be shown for alternative investments. The TPA clarifies that major categories
disclosed for alternative investments should be tailored to the specific nature and risks of the reporting
entity’s alternative investments. In the absence of a diversified portfolio of alternative investments (e.g.,
hedge, private equity, venture, real estate), the reporting entity may consider more specific categories
(e.g., industry, geography, strategy) that allow readers to further understand the risks and exposures
associated with the alternative investment categories. ASU 2010-06, which was issued in January 2010
(see discussion above), changed the terminology from “major categories” to “classes” and provides crossreferences to guidance in ASC 820-10 on how to present appropriate classes for fair value measurement
disclosures.
In general, entities should remember that changes in how an entity values its alternative investments
may, if significant, trigger additional disclosure requirements. Additional guidance on this subject may be
forthcoming from the AICPA.
TPA on Business Combinations
In December 2009, the AICPA issued TIS Section 6910.33 on business combinations. The TPA notes that
when a transaction or other event meets the definition of a “business combination,” ASC 805-10-50
requires, among other things (1) the “identification of the acquiree,” (2) the recognition and measurement
of “identifiable assets acquired and liabilities assumed, at the acquisition date, generally at their fair
values,” and (3) “[d]isclosure, by the acquirer, of information that enables users of its financial statements
to evaluate the nature and financial effect of a business combination that occurs during the current
reporting period.”
The TPA describes some of the financial reporting, disclosure, regulatory, and tax guidance that should be
considered in preparing financial statements of investment companies involved in a business combination:
When investment companies engage in a business combination, shares of one company typically are
exchanged for substantially all the shares or assets of another company (or companies). Most mergers
of registered investment companies are structured as tax-free reorganizations. Following a business
combination, portfolios of investment companies are often realigned, subject to tax limitations, to
fit the objectives, strategies, and goals of the surviving company. Typically, shares of the acquiring
fund are issued at an exchange ratio determined on the acquisition date, essentially equivalent to the
acquiring fund’s [NAV] per share divided by the NAV per share of the fund being acquired, both as
calculated on the acquisition date. Adjusting the carrying amounts of assets and liabilities is usually
unnecessary because virtually all assets of the combining investment companies (investments) are
stated at fair value, in accordance with [ASC 820] and liabilities are generally short-term so that their
carrying values approximate their fair values. [Footnote omitted] However, conforming adjustments
may be necessary when funds have different valuation policies (for example, valuing securities at the
bid price versus the mean of the bid and asked price) in order to ensure that the exchange ratio is
equitable to shareholders of both funds.
Only one of the combining companies can be the legal survivor. In certain instances, it may not be
clear which of the two funds constitutes the acquirer for financial reporting purposes. Although the
legal survivor would normally be considered the acquirer, continuity and dominance in one or more of
the following areas might lead to a determination that the fund legally dissolved should be considered
the acquirer for financial reporting purposes:
Section 4: Asset Management Sector Supplement
•
Portfolio management
•
Portfolio composition
81
•
Investment objectives, policies, and restrictions
•
Expense structures and expense ratios
•
Asset size
A registration statement on Form N-14 is often filed in connection with a merger of management
investment companies registered under the Investment Company Act of 1940 (the Act), or of business
development companies as defined by the Act. Form N-14 is a proxy statement in that it solicits a vote
from the (legally) acquired fund’s shareholders to approve the transaction, and a prospectus, in that it
registers the (legally) acquiring fund’s shares that will be issued in the transaction. Form N-14 frequently
requires the inclusion of pro forma financial statements reflecting the effect of the merger. . . .
Merger-related expenses (mainly legal, audit, proxy solicitation, and mailing costs) are addressed in the
plan of reorganization and are often paid by the fund incurring the expense, although the adviser may
waive or reimburse certain merger-related expenses. Numerous factors and circumstances should be
considered in determining which entity bears merger-related expenses.
In accordance with FASB ASC 805-10-25-23, acquisition related costs are accounted for as expenses
in the periods in which the costs are incurred and the services are received, except that costs to issue
equity securities are recognized in accordance with other applicable U.S. generally accepted accounting
principles.
If the combination is a taxable reorganization, the fair value of the assets acquired on the date of the
combination becomes the assets’ new cost basis. For financial reporting purposes, assets acquired
in a tax-free reorganization may be accounted for in the same manner as a taxable reorganization.
However, investment companies carry substantially all their assets at fair value as an ongoing reporting
practice and cost basis is principally used and presented solely for purposes of determining realized
and unrealized gain and loss. Accordingly, an investment company, which is an acquirer in a business
combination structured as a tax-free exchange of shares, may make an accounting policy election to
carry forward the historical cost basis of the acquiree’s investment securities for purposes of measuring
realized and unrealized gain or loss for statement of operations presentation in order to more closely
align the subsequent reporting of realized gains by the combined entity with tax-basis gains distributable to shareholders. The basis for such policy election should be disclosed in the notes to the financial
statements, if material.
Instructions to Forms N-1A and N-2 state that, for registered investment companies, costs of purchases
and proceeds from sales of portfolio securities that occurred in the effort to realign a combined fund’s
portfolio after a merger should be excluded in the portfolio turnover calculation. The amount of
excluded purchases and sales should be disclosed in a note. [Footnote omitted]
FASB ASC 805-10-50-1 states that disclosures are required when business combinations occur during
the reporting period or after the reporting date but before the financial statements are issued.
In accordance with FASB ASC 805-10-50, 805-20-50, and 805-30-50, disclosures for all business
combinations should include a summary of the essential elements of the combination; that is, the
name and description of the acquiree, the acquisition date, the percentage of voting equity interests
acquired, the primary reasons for the combination and the manner in which control was obtained,
the nature of the principal assets acquired, the number and fair value of shares issued by the acquiring
company, and the exchange ratio. In addition, public business enterprises are required to disclose
supplemental pro forma information consisting of the revenue and earnings of the combined entity for
the current reporting period as though the acquisition date for all business combinations had been as
of the beginning of the acquirer’s annual reporting period.
Public business enterprises are also required to report, if practicable, the amounts of revenue and
earnings of the acquiree since the acquisition date included in the combined entity’s income statement
for the reporting period. In many cases, investments acquired are absorbed into and managed as an
integrated portfolio by an investment company upon completion of an acquisition; therefore, providing
this information will not be practicable. That fact, along with an explanation of the circumstances,
should be disclosed.
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Because of the importance of investment company taxation to amounts distributable to shareholders,
certain additional disclosures are recommended for combinations of investment companies, including
the tax status and attributes of the merger. Additionally, if the merger is a tax-free exchange, separate
disclosure of the amount of unrealized appreciation or depreciation and the amount of undistributed
investment company income of the acquiree at the date of acquisition, if significant, may provide
meaningful information about amounts transferred from the acquiree, which may be distributable by
the combined fund in future periods.
The TPA contains financial statements and disclosures that illustrate a tax-free business combination of an
investment company as well as illustrative footnotes that are unique to a business combination.
Registration of Fund Advisers With the SEC
Private fund advisers, including managers of hedge funds and private equity funds, with assets under
management in the United States of more than $150 million will be required to register with the SEC
under the Investment Advisers Act of 1940 (“the Adviser’s Act”) per the requirements of the Dodd-Frank
Act, by July 21, 2011. Exemptions from registration will be allowed for venture capital advisers, small
business investment advisers, family office advisers (on the basis of exemptions currently provided by the
SEC), and small foreign private fund advisers that meet certain requirements, including having fewer than
15 investors in the United States and less than $25 million in assets under management attributable to
U.S. investors. Subject to SEC rules, registered private fund advisers must maintain and file reports related
to the assessment of systemic risk for each private fund.
Rule 203-1 of the Advisers Act requires investment advisers to register with the SEC by filing Form ADV,
which is divided into two parts. Part 1 requires general information about the adviser, including business
practices, ownership and control, regulatory and disciplinary history, relevant state registrations, access
to client funds, and balance sheet information. Part 2 is the written disclosure statement (brochure) and
requires detailed information about the adviser, such as affiliations and conflicts, types of services offered
and fees charged, types of clients advised and investment strategies used, educational and business
backgrounds of investment professionals, disciplinary histories, investment advisory activities, brokerage
practices and allocation, trade aggregation and allocation, code of ethics and personal trading, and proxy
voting.
The complexity of the adviser’s organization as well as the resources devoted to the effort will determine
the duration of the registration process. Time frames from start to finish can range from three to nine
months. Before registration, companies should develop and adopt a compliance program that meets
applicable requirements under the Advisers Act and train employees on relevant requirements.
Registered investment advisers are required to report information on their funds, including the following:
•
AUM and use of leverage, including off-balance-sheet leverage.
•
Counterparty credit risk exposure.
•
Trading and investment positions.
•
Valuation policies and practices of the fund.
•
Types of assets held.
•
Side arrangements or side letters.
•
Trading practices.
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•
Other information that the SEC, in consultation with the FSOC, deems appropriate for
the protection of investors or for the assessment of systemic risk, which may include the
establishment of different reporting requirements for different classes of fund advisers, based on
the type or size of private fund being advised.
Item 18: Financial Information, of Form ADV requires disclosure of certain financial information about an
adviser when it is material to clients. Specifically, an adviser that requires prepayment of fees of more than
$1,200 must provide its clients with an audited balance sheet showing the adviser’s assets and liabilities at
the end of its most recent fiscal year. Therefore, an adviser considering first-time registration with the SEC
should determine whether an audit of its balance sheet is required.
See Section 1 for further details.
Usage of Derivative Instruments
In March 2010, the SEC staff indicated in a press release that it would be “conducting a review to
evaluate the use of derivatives by mutual funds, exchange-traded funds and other investment companies,
[to determine if any] additional protections are necessary for those funds under the Investment Company
Act of 1940.” The goal of the review is to ensure that regulatory protections keep up with the increasing
usage and complexity of derivative instruments.
According to the press release, “the staff generally intends to explore issues related to the use of
derivatives by funds.” Such issues include, among other things, whether:
•
current market practices involving derivatives are consistent with the leverage, concentration
and diversification provisions of the Investment Company Act
•
funds that rely substantially upon derivatives, particularly those that seek to provide leveraged
returns, maintain and implement adequate risk management and other procedures in light of
the nature and volume of the fund’s derivatives transactions
•
fund boards of directors are providing appropriate oversight of the use of derivatives by funds
•
existing rules sufficiently address matters such as the proper procedure for a fund’s pricing and
liquidity determinations regarding its derivatives holdings
•
existing prospectus disclosures adequately address the particular risks created by derivatives
•
funds’ derivative activities should be subject to special reporting requirements
The staff also will seek to determine what, if any, changes in Commission rules or guidance may be
warranted.
On July 30, 2010, the SEC’s Division of Investment Management sent a letter to the Investment Company
Institute about its observations on current derivatives-related disclosures by investment companies in
registration statements and shareholder reports. According to the letter, the SEC primarily observed
that certain “funds provide generic disclosures about derivatives that . . . may be of limited usefulness
for investors in evaluating the anticipated investment operations of the fund, including how the fund’s
investment adviser actually intends to manage the fund’s portfolio and the consequent risks. [Footnote
omitted] The generic disclosures vary from highly abbreviated disclosures that briefly identify a variety of
derivative products or strategies, to lengthy, often highly technical, disclosures that detail a wide variety of
potential derivative transactions without explaining the relevance to the fund’s investment operations.”
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The SEC also noted that some funds could improve their disclosures under ASC 815’s requirement to
provide qualitative information about their objectives and strategies for using derivative instruments by
addressing the effect of using derivatives during the reporting period. While many funds state that they
“may” engage in certain types of derivative transactions, they do not provide qualitative information
about how the funds achieved their objectives and strategies by using derivative instruments during the
reporting period. The financial statements and accompanying notes should inform shareholders about
how a fund actually used derivatives during the period to meet its objectives and strategies.
Collective Unit Trusts
In a speech in April 2010, a director of the SEC’s Division of Investment Management indicated that the
SEC is investigating whether there may be a need for regulatory recommendations regarding the use of
collective investment trust platforms, which has increased in recent years. Collective investment trusts
are, according to the speech, “regulated by the banking agencies, and may rely on an exclusion from
registration under the Investment Company Act. The premise underlying this exclusion is that banks
exercise full investment authority over the pooled assets, among other things. As collective investment
trusts become more popular and their structures more varied, the Division is looking at whether, under
certain conditions, this exemption is properly relied upon and consistent with the Act and whether it
denies investors appropriate protections.” The SEC will consider whether banks are “operating merely in
custodial or similar capacity while providing a place for an adviser to simply place pension plan assets of
its clients.”
Target Date Fund Disclosures
In June 2010, the SEC proposed amendments to Rule 482 of the Securities Act and Rule 34b-1 of the
Investment Company Act that, if adopted, would require:
•
A “target date retirement fund that includes the target date in its name to disclose the fund’s
asset allocation at the target date immediately adjacent to the first use of the fund’s name in
marketing materials.”
•
Marketing materials for target date retirement funds that would include “a table, chart, or graph
depicting the fund’s asset allocation over time, together with a statement that would highlight
the fund’s final asset allocation.”
•
A statement in marketing materials “to the effect that a target date retirement fund should not
be selected based solely on age or retirement date, is not a guaranteed investment, and the
stated asset allocations may be subject to change.”
The SEC is also proposing amendments to Rule 156 of the Securities Act that, if adopted, “would
provide additional guidance regarding statements in marketing materials for target date retirement funds
and other investment companies that could be misleading. The amendments are intended to provide
enhanced information to investors concerning target date retirement funds and reduce the potential for
investors to be confused or misled regarding these and other investment companies.”
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Joint Project on Financial Statement Presentation
On July 1, 2010, the FASB and IASB posted to their Web sites a staff draft of an ED on financial statement
presentation. The staff draft reflects the boards’ tentative decisions through April 2010; however, work on
the project is continuing and the proposal is subject to change before the boards issue an ED for public
comment. As part of the project, the boards are also conducting outreach activities focused primarily on
“(1) the perceived benefits and costs of the proposals and (2) the implications of the proposals for financial
reporting by financial services entities.” Although the boards have not formally requested comments
on the staff draft, they welcome input from interested parties. Before publishing an ED, the boards will
consider whether to revise any of their decisions on the basis of the input they receive.
In the staff draft, the boards take a fresh look at the manner in which financial information is presented
in an entity’s statement of financial position, statement of comprehensive income, and statement of cash
flows. The intent of the proposal is to create a single model for presenting financial statements that will
enhance the usefulness of the information provided in the financial statements and increase comparability
and consistency within and across entities. The proposed guidance would apply to most entities. Currently,
there is limited guidance on how entities should present information in their financial statements.
As a result, alternative presentations have developed, creating inconsistencies among similar entities
and difficulties in understanding relationships within an entity’s financial statements. Accordingly, the
introduction to the staff draft identifies the following “core principles” of financial statement presentation
to “enhance the understandability” of an entity’s financial information:
• Cohesiveness: “the relationship between items in the financial statements is clear and that an
entity’s financial statements complement each other as much as possible.”
• Disaggregation: “separating resources by the activity in which they are used and by their
economic characteristics.”
Joint Project on Consolidation
Under IFRS, the accounting for consolidation is currently addressed by IAS 27, a control-based model, and
by SIC-12, a risks-and-rewards-based model. Under U.S. GAAP, consolidation is addressed by ASC 810-10
for both the variable interest model and the voting interest model. The objective of the joint project is to
develop a single comprehensive consolidation model that would apply to all entities, including both voting
and VIEs, and to require enhanced disclosures about consolidated and unconsolidated entities.
In their meeting on May 19, 2010, the boards tentatively decided that when preparing consolidated
financial statements, the parent of an investment company (if it is not an investment company itself) is
prohibited from retaining the fair value accounting that is applied by an investment company subsidiary.
(This reverses the FASB’s previous tentative decision to allow the parent of an investment company
subsidiary to retain the fair value measurement basis applied by the investment company.) Accordingly, a
parent of an investment company would be required to consolidate all entities that it controls, including
those that are controlled by an investment company subsidiary, unless that parent is an investment
company itself.
The boards also tentatively decided that if a reporting entity has an interest in an investment company
that it accounts for by using the equity method, it should retain the fair value accounting that is applied by
an investment company subsidiary when applying the equity method accounting.
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As part of their joint deliberations, the boards also reached the following additional tentative decisions:
•
The guidance in ASC 946 would be used as the basis for developing the attributes of an
investment company.
•
An investment company is an entity that meets all of the following criteria:
1. Express business purpose. The express business purpose of an investment company is investing
for current income, capital appreciation, or both.
2. Exit strategy. The entity has identified potential exit strategies and a defined time (or range of
dates) at which it expects to exit the investment.
3. Investment activity. Substantially all of the entity’s activities are investment activities carried
out for the purposes of generating current income, capital appreciation, or both. The entity
and its affiliates shall not obtain benefits from its investees that would be unavailable to other
investors or unrelated parties of the investee.
4. Unit ownership. Ownership in the entity is represented by units of investments.
5. Pooling of funds. The funds of the entity’s owners are pooled to avail owners of professional
investment management.
6. Fair value. All of the investments are managed, and their performance evaluated (both internally and externally), on a fair value basis.
7. Reporting entity. The entity must be a reporting entity.
8. Debt. Any providers of debt to the investees of the entity shall not have direct recourse to any
of the entity’s other investees.
The Boards asked the staff[s] to clarify some aspects of the criteria in drafting. In particular, the Boards
asked that it be clear that significant third-party investment is required for an entity to be an investment company.
Disclosure
An investment company should disclose the following:
•
Whether it has provided any financial or other support to any of its controlled investees that it
was not previously contractually required to provide.
•
The nature and extent of any significant restrictions on the ability of its controlled investees to
transfer funds to the investment company.
Further, the boards tentatively agreed that an investment company should not be required to present
summarized financial information for controlled investments.
Transition
The FASB tentatively decided that an entity currently applying the investment company guidance in ASC
946 should discontinue the application of this guidance if it no longer qualifies as an investment company.
This change should be applied prospectively from the date the revised consolidation requirements are first
applied. For those investees that are required to be consolidated because an entity no longer qualifies as
an investment company, the entity should apply the same transition guidance for all other entities that will
be required to be consolidated as a result of the revised consolidation requirements.
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Both the FASB and the IASB tentatively decided that an entity that was not previously considered an
investment company, but meets the new definition of an investment company, should recognize its
investments in entities that it controls at fair value on the date that it first applies the revised consolidation
requirements and should make an adjustment to retained earnings.
In the second quarter of 2011, the boards expect to issue an ED. The FASB hopes to issue a final
standard in the fourth quarter of 2011.
Joint Project on Financial Instruments
The FASB and IASB have agreed on a set of core principles for financial instruments accounting. The
core principles are designed to achieve comparability and transparency as well as consistency of credit
impairment models and reduced complexity of financial instruments accounting. The boards agreed that:
•
Any requirements issued by the boards should enhance comparability of information for the
benefit of investors.
•
Financial reporting of financial instruments should provide information that helps investors assess
the risks associated with those instruments.
•
For financial instruments that have highly variable cash flows or that are part of a trading
operation, prominent and timely information about the fair values of those instruments is
important.
•
For financial instruments with principal amounts that are held for collection or payment of
contractual cash flows rather than for sale or settlement with a third party, information about
both amortized cost and fair value is relevant to investors.
•
The classification and measurement requirements should be less complex to implement than are
the current requirements.
•
Impairment principles should be consistent for all instruments held for collection of their
contractual cash flows.
On May 26, 2010, the FASB issued a proposed ASU, Accounting for Financial Instruments and Revisions
to the Accounting for Derivative Instruments and Hedging Activities. The proposed ASU contains a
comprehensive new model of accounting for financial assets and financial liabilities that addresses (1)
recognition and measurement, (2) impairment, and (3) hedge accounting. The proposal would significantly
affect the accounting for a broad range of financial instruments, including investments in debt and equity
securities, nonmarketable equity investments, loans, loan commitments, deposit liabilities, trade payables,
trade receivables, derivative financial instruments, and debt liabilities. Comments on the proposed ASU
were due by September 30, 2010.
Roundtable discussions are ongoing in the fourth quarter of 2010, and a final standard is expected to be
issued by June 30, 2011. The effective date of the final standard has not yet been determined.
Three items in the proposed ASU could significantly affect the asset management industry:
•
Transaction fees and costs would be “(1) expensed immediately for financial instruments
measured at fair value with all changes in fair value recognized in net income and (2) deferred
and amortized as an adjustment of the yield for financial instruments measured at fair value
with qualifying changes in fair value recognized in OCI.” This could affect income statement
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presentation, in particular for investment companies that currently report transaction costs within
net income in the “realized and unrealized gain or loss from investments” category and not as
part of “investment income and expenses.” Certain ratios, such as expense ratios, would be
affected as a result.
•
Money markets funds that may have measured financial instruments at amortized cost under Rule
2a-7 of the Investment Company Act would be required to instead measure them at fair value if
certain conditions are met.
•
The proposed ASU would result in a significant number of financial liabilities being measured
at fair value when such financial liabilities were previously measured at cost or subject to the
embedded derivative bifurcation requirements in ASC 815.
Joint Project on Financial Instruments With Characteristics of Equity
The FASB’s and IASB’s project on financial instruments with characteristics of equity is intended to improve
and simplify, through development of a new classification approach, the financial reporting of financial
instruments considered to have one or more characteristics of equity. The boards have decided to propose
that entities provide disclosures about the nature and terms of the instruments, including information
about settlement alternatives, in addition to the disclosures currently required by U.S. GAAP and IFRSs.
The project may affect the balance sheet classification for redeemable interests in investment companies.
Joint Project on Revenue Recognition
On June 24, 2010, the FASB and IASB issued an ED, Revenue From Contracts With Customers. The ED
gives entities a single comprehensive model to use in reporting information about the amount and timing
of revenue resulting from contracts to provide goods or services to customers. It applies to any entity
that enters into contracts to provide goods or services, and would supersede most of the current revenue
recognition guidance. Comments on the ED were due by October 22, 2010.
In applying the ED’s provisions to contracts within its scope, an entity would:
(a) identify the contract(s) with a customer;
(b) identify the separate performance obligations in the contract;
(c) determine the transaction price;
(d) allocate the transaction price to the separate performance obligations; and
(e) recognize revenue when the entity satisfies each performance obligation.
The ED also requires entities to disclose both quantitative and qualitative information about the amount,
timing, and uncertainty of revenue (and related cash flows) from contracts with customers and the
judgment, and changes in judgment, they exercised in applying the ED’s provisions. The disclosures
required by the ED would significantly expand those currently required by existing revenue standards and
would include:
•
Information about the nature of customer contracts and the related accounting policies.
•
A disaggregation of reported revenue (in categories that best depict how the amount, timing,
and uncertainty of revenues and cash flows are affected by economic characteristics).
•
A reconciliation of the beginning and ending contract assets and liabilities.
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•
Information about performance obligations (types of goods/services, payment terms, timings,
etc.).
•
Information about onerous contracts, including the extent and amount of such contracts and the
reasons they became onerous.
•
A description of the principal judgments used in accounting for contracts with customers.
•
Information about the methods, inputs, and assumptions used in determining and allocating the
transaction prices.
Roundtable discussions are continuing in the fourth quarter of 2010, and a final standard is expected to
be issued in the second quarter of 2011. Although the ED’s impact on asset management companies is
not yet clear, there may be implications related to the recognition and disclosure requirements for certain
management and performance fee arrangements.
See Section 3 for further details on FASB and IASB projects.
Other Developments
In January 2010, the CFA Institute released revised global investment performance standards (the “GIPS
standards”). The significant changes to the GIPS standards include the requirement for entities (1) to
value assets by using a fair value method when no market value is available, (2) to present the standard
deviation (widely accepted as a common measure of portfolio risk) of the monthly returns of both the
composite and the benchmark, and (3) to disclose their verification status (i.e., whether they have been
verified) and prescribed language describing what is and is not covered by verification. Firms that claim
compliance with the GIPS standards have until January 1, 2011, to adhere to the new requirements, and
early adoption is recommended.
Regulatory Sector Supplement — Asset Management
New Form ADV, Part 2
On August 12, 2010, the SEC adopted changes1 to Part 2 (formerly Part II) of Form ADV, the second
component of the registration form and client disclosure document used by investment advisers registered
under the Advisers Act. Part 2 of the new Form ADV (the “brochure”) requires registered advisers to
provide most clients and prospective clients with a “brochure” containing clearer and more meaningful
disclosure of their business practices, potential conflicts of interest, and personnel backgrounds. The new
brochure must be presented in a narrative, “plain English” format rather than the current “check-the-box”
format. Furthermore, advisers must provide clients with a brochure supplement that contains, among
other things, background information on certain supervised persons providing advisory services to clients,
including their disciplinary history, outside business activities, and compensation arrangements.
Advisers are required to electronically file the brochures with the SEC. The most recent versions of the
brochures will be posted on the SEC’s Web site.
Brochures that meet the new requirements must be filed within 90 days of an adviser’s first fiscal year-end
on or after December 31, 2010, and must be delivered to clients within 60 days of this filing; the client
delivery requirement changes to 30 days for subsequent Form ADV filings. The new brochure requirements
SEC Final Rule Release No. IA-3060, Amendments to Form ADV.
1
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are likely to apply to advisers registering for the first time in response to the Dodd-Frank Act, depending
on the date of the advisers’ ADV filings.
Narrative Brochure Written in “Plain English”
The SEC believes that a narrative format will give advisers greater flexibility to present more meaningful,
relevant information to investors.2 Certain SEC commissioners have observed that for the narrative
requirement to be effective, however, advisers will need to adopt the “spirit” of the requirement and
move away from the standard boilerplate language often used by advisers to protect against legal liability.3
Toward this end, advisers must use “plain English” (e.g., short sentences, everyday words, and the active
voice). In addition, in an effort to avoid cluttering their brochures with irrelevant disclosures or practices,
advisers should disclose only conflicts and business practices that they have (or are reasonably likely to
have).
Key Changes to the Brochure’s Content
In addition to changing the brochure’s format requirements, the SEC has included several new disclosure
requirements in Part 2 of the new Form ADV (e.g., summary of material changes from the previous year,
information about performance-based fees and side-by-side management) and has amended many of
the current disclosure requirements. Part 2 is now broken down into two sections: Part 2A, referred to as
the “firm brochure,” consists of 18 disclosure items related to the adviser’s activities as a whole; Part 2B,
referred to as the “brochure supplement,” consists of six new disclosure items specific to the experience
and activities of certain supervised persons4 that provide advisory services to clients.
Brochure Supplements
Advisers must supply tailored brochure supplements disclosing background information about certain
supervised persons who provide advisory services to clients. Under the previous brochure requirements,
advisers had to disclose background information only about executives and members of investment
committees. The SEC indicated that such disclosure was not relevant to clients, especially clients of
larger asset management firms, who receive advisory services primarily from supervised persons who
are not executives or members of the investment committee. Instead, advisers will be asked to disclose,
among other things, information regarding each supervised person’s education and business experience,
disciplinary history, other substantial investment-related activities, potential conflicts of interest, and
additional compensation. The brochure supplements must be delivered either before or when the
supervised person begins to provide advisory services to a client. If any other material changes occur
during the year, the adviser is required to deliver annually an updated brochure supplement to the
applicable clients. Although advisers are not required to file brochure supplements with the SEC, they must
make these supplements available during an SEC inspection.
Key Changes to Delivery Requirements
The SEC has also changed how and when advisers distribute brochures to clients. Advisers must file their
firm brochures electronically with the SEC as part of their initial registration and at least annually thereafter
via the IARD. The firm brochures will be publicly available on the SEC’s Web site. An adviser’s annual filings
See Section II.D.2 of SEC Proposed Rule Release No. IA-1862, Electronic Filing by Investment Advisers; Proposed Amendments to Form ADV, April 5,
2000.
2
See July 21, 2010, SEC Open Meeting on the SEC’s Web site.
3
Instruction 1 of Part 2B of Form ADV requires advisers to prepare a brochure supplement for (1) any supervised person who formulates investment
advice for, and has direct contact with, the client and (2) any supervised person who has discretionary authority over a client’s assets, even if the
person has no direct client contact.
4
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are due no later than 90 days after its fiscal year-end. In addition to filing the brochure, advisers must
annually deliver to clients a summary of material changes to the brochure, along with an offer to provide
the brochure and brochure supplement upon request.
Money Market Reform
On February 23, 2010, the SEC issued a final rule5 on money market fund reform that amends Rules
2a-7 and 17a-9 of the Investment Company Act. The final rule is designed to increase the protection of
investors, improve fund operations, and enhance fund disclosures.
More specifically, the amendments:6
•
Tighten the risk-limiting conditions by reducing the maximum weighted-average maturity of the
portfolio permitted for money market funds, increasing liquidity limits, and restricting the fund’s
ability to invest in securities with lower credit ratings.
•
Require money market funds to disclose, on a monthly basis, their “shadow” floating share price,
with a 60-day lag until this information becomes publicly available.
•
Require money market funds to report, on a monthly basis, their portfolio holdings to the SEC.
•
Permit money market funds that “break the buck” (or that are at imminent risk of doing so) to
suspend redemptions to allow for an orderly liquidation.
•
Require fund managers to conduct periodic stress tests to assess the fund’s ability to maintain a
stable net asset value.
•
Limit the type of collateral for repurchase agreements.
•
Increase oversight responsibility for fund advisers.
•
Require boards of directors of money market funds to designate four or more NRSROs so that the
funds can adequately evaluate the eligibility of portfolio securities.
The amendments became effective on May 5, 2010, with rolling effective dates for certain provisions
through October 31, 2011.
The Dodd-Frank Act, signed into law on July 21, 2010, has potential implications for the final rule because
it mandates the SEC to conduct a review to assess current standards of creditworthiness. In response to
a request from the Investment Company Institute, the SEC issued a no-action letter on August 19, 2010,
regarding the designation of NRSROs. The no-action letter indicates that the Division of Investment
Management would not recommend that the SEC take any enforcement action against money market
fund boards that opt not to (1) designate four or more NRSROs, (2) disclose the NRSROs in their
statements of additional information, or (3) both of these.7
See SEC Final Rule Release No. IA-3043, Political Contributions by Certain Investment Advisers, on the SEC’s Web site.
7
SEC Final Rule Release No. IC-29132, Money Market Fund Reform.
5
For more information about the reforms, see the press release on the SEC’s Web site.
6
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New Rules for a New Era: The SEC Adopts “Pay-to-Play” Rules
The SEC recently adopted new and amended rules under the Advisers Act to deter investment advisers
from engaging in “pay-to-play” practices. The rules restrict campaign contributions to politicians who may
be in a position to (1) influence the selection of advisers to manage state and local pension funds and
other investment plans or (2) impose new requirements.
Direct Political Contributions
Rule 206(4)-5 prohibits an adviser from providing advisory services for compensation to a “government
entity”8 for two years after the date of an impermissible political contribution9 by the adviser or its
“covered associates”10 to an “official”11 of the government entity with responsibility for, or influence
over, the adviser’s hiring. The new rule also applies to “covered investment pools,” which include private
investment funds and registered investment companies (but only those that are part of a state or local
government’s investment program).
Rule 206(4)-5(b)(1) permits de minimis contributions by covered associates. A covered associate that
is entitled to vote for the candidate can make an aggregate campaign contribution of up to $350 per
government official, per election; otherwise, the associate’s campaign contribution is limited to $150.
Primary and general elections count separately.
Indirect Political Contributions
Rule 206(4)-5(d) prohibits advisers and covered associates from taking indirect actions that would be
prohibited if done directly. These actions include:
•
Asking another person or group (such as a PAC) to make a contribution.
•
Soliciting or coordinating payments to a state or local political party when advisory services are
sought.
•
Indirectly coordinating or sponsoring contributions (e.g., fund-raising events).
Solicitation Services
Rule 206(4)-5(a)(2)(i) prohibits advisers and covered associates from paying a third party to solicit state and
local government clients on the adviser’s behalf unless the third party is a “regulated person.” A regulated
person is a party who is either (1) an SEC-registered investment adviser who has made no impermissible
contributions within the previous two years or (2) an SEC-registered broker-dealer and a member of a
national securities association such as FINRA.
A government entity is a state, political subdivision, agency, or instrumentality; a pool of assets sponsored or established by such an entity (e.g.,
defined benefit plans); an entity’s plans or programs (including 403(b), 457, and 529 plans); and officers, agents, or employees of such an entity.
Government entities do not include the federal government, its agencies and instrumentalities, or non-U.S. governments.
8
A contribution includes anything of value given to influence an election, pay an election debt, or fund transition or inaugural expenses. Contributions
may include those related to federal elections if the official has influence over the adviser’s hiring as a function of his or her current office.
9
A covered associate is (1) any general partner, managing member, executive officer, or other individual with a similar status or function; (2) any
employee who solicits a government entity for the adviser and any person who supervises, directly or indirectly, such an employee; and (3) any
PAC controlled by the adviser or by any of its covered associates. Soliciting means communicating with a government entity to obtain or retain an
investment advisory relationship or to receive a related referral fee.
10
A government official is an incumbent or candidate, if the person has (1) direct or indirect responsibility for or influence over the outcome of an
adviser’s hiring by a government entity or (2) the authority to appoint such a person.
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Recordkeeping
Under the amendments to Rule 204-2, advisers who provide advisory services to state and local
governments must keep records of the following for five years:
•
The adviser’s covered associates.
•
Government clients who (1) receive direct advisory services or (2) have invested in covered
investment pools during the past five years (starting September 13, 2010).
•
Relevant contributions made by the adviser and covered associates.
•
Regulated persons providing solicitation services.
Compliance Dates
Although the new and amended rules become effective on September 13, 2010, compliance with the
new requirements is being implemented in phases. The compliance deadline for the compensation ban,
monitoring, and client recordkeeping requirements is March 14, 2011, and advisers must comply with the
third-party solicitor restrictions and covered investment pool requirements by September 13, 2011.
Operational Impacts
The new provisions will most likely necessitate changes to advisers’ policies, compliance monitoring,
and record-keeping practices. Advisers should incorporate these changes as part of a robust compliance
program. The following are key considerations:
Topic
Considerations
Understanding covered
associates
• Identifying the population of employees.
Understanding
government officials
• Identifying the ability to influence the adviser’s selection.
Determining candidate
scope
• Identifying in-scope federal candidates.
Managing the code
of ethics or other
compliance policies
• Incorporating new contribution policies, including potentially banning or imposing
preclearance requirements.
• Identifying responsibility for the adviser’s selection.
• Notifying covered associates of their status and receiving acknowledgments.
• Training covered associates and others.
Contribution monitoring
• Establishing procedures and infrastructure for covered-associate self-reporting.
• Developing a report process for adviser PAC contributions.
• Establishing detective mechanisms for indirect, inadvertent contributions.
Contribution tracking
• Reviewing an employee’s two-year political contribution history upon hiring or
reclassification to a covered associate (limited to six months if the employee does not
solicit any clients after becoming a covered associate).
• Continuing to abide by restrictions on compensated advisory services for two years
following an impermissible contribution, even if an employee departs or ceases to be a
covered associate within the two-year time frame.
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Topic
Considerations
Third-party solicitor
tracking
• Identifying regulated persons.
Understanding covered
investment pools
• Identifying in-scope pooled investment vehicles.
Recordkeeping
• Gathering and maintaining new required documentation.
• Tracking evolving government investment plan/program arrangements.
SEC Rule 206(4)-2 — “Custody Rule” Summary
On December 30, 2009, the SEC finalized amendments to Rule 206(4)-2 (the “Custody Rule”) under the
Advisers Act. The Custody Rule took effect on March 12, 2010.
The Custody Rule can affect advisers differently depending on the method (i.e., amount of discretion
conveyed) and type of client accounts they manage. An adviser is deemed to have “custody” if (1) the
adviser or a related person holds, directly or indirectly, client funds or securities or (2) the adviser has
the authority to obtain possession of client funds or securities or the related person has such authority
in connection with advisory services the adviser provides to clients.12 If an adviser has custody of funds
solely as a consequence of authority to make withdrawals from client accounts to pay advisory fees, it is
exempt from the surprise examination requirements. The Custody Rule can apply in many different ways,
depending on the type of client accounts or pooled vehicles in the adviser’s custody. Some advisers may
only need to have their qualified custodians distribute quarterly account statements to their clients. Others
may also need to undergo a surprise examination, receive an internal control report from their qualified
custodian, or both.
The staff of the SEC’s Division of Investment Management has posted numerous questions and responses
regarding the Custody Rule on the SEC’s Web site.13
The AICPA Investment Companies Expert Panel also issued a FAQ document in August 2010 regarding the
Custody Rule.14
For more information, see Deloitte’s Custody Rule Overview: Navigating the Road Ahead.
12
See the SEC Staff Responses to Questions About the Custody Rule document on the SEC’s Web site.
13
AICPA Investment Companies Expert Panel Report, Frequently Asked Questions Regarding the SEC’s Revised Custody Rule and Guidance for
Accountants.
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Section 5
Banking and Securities Sector Supplement
Banking and Securities Accounting Update
This section discusses recent accounting developments that are of specific interest to the banking
and securities sector. It should be read in conjunction with Sections 1 and 2, which address other key
accounting considerations that apply more broadly to financial services entities and may be relevant to the
asset management sector.
“Dear CFO” Letter on Repurchase Agreements
In March 2010, the SEC staff issued a standard Dear CFO letter seeking more information on the
accounting for and use of repurchase arrangements. While the letter does not replace or amend existing
GAAP, the SEC has requested registrants to enhance disclosures about these types of transactions,
including:
•
Any securities lending transactions that are accounted for as sales under ASC 860-10, the basis
for that accounting, and quantification of the amount of these transactions.
•
Any other transactions involving the transfer of financial assets with an obligation to repurchase
the transferred assets, in a manner similar to repurchase or securities lending transactions that
would be accounted for as sales under ASC 860.
•
Any offset of financial assets and financial liabilities in the balance sheet in which a right of setoff
(i.e., the general principle for offsetting) does not exist.
In addition, the SEC staff is seeking to understand the timing, nature, and extent to which companies
are using repurchase agreements accounted for as sale transactions, including any counterparty
concentrations, the impact of repurchase agreements on key ratios or metrics, and the business purpose
of these transactions.
Loss-Sharing Arrangements
LSAs are guarantees provided to financial institutions by the FDIC in connection with either (1) a
government-facilitated acquisition of a bank or (2) a purchase of a pool of high-risk assets (either existing
assets or assets recently purchased in a government-sponsored transaction). An LSA typically provides
for the reimbursement of a portion of the principal losses incurred on the acquired portfolio over a fixed
and stated time frame, generally with a “first loss threshold” to be incurred by the acquiring financial
institution. Recent transactions have also included a clawback feature that would give the FDIC a share in
any recoveries of loans previously covered by payments under the program.
The FDIC uses two forms of loss sharing: one for commercial assets and one for residential mortgages.
A typical LSA for commercial assets covers an eight-year period, with the first five years for losses and
recoveries and the final three years for recoveries only. The FDIC will reimburse 80 percent of losses
incurred by the acquirer on covered assets up to a stated threshold amount (generally the FDIC’s dollar
estimate of the total projected losses on loss share assets), with the acquiring institution absorbing the
remaining 20 percent.
LSAs for single-family mortgages tend to run 10 years and have the same 80/20 split as commercial asset
LSAs. The FDIC provides coverage on some second lien loans for four basic single-family mortgage loss
events: modification, short sale, foreclosure, and charge-off. Loss coverage is also provided for loan sales,
but such sales require prior approval by the FDIC. Recoveries on loans that experience loss events are split
evenly between the acquirer and the FDIC.
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Since the inception of LSAs, the basis for sharing losses with an acquirer has undergone some change.
Until March 26, 2010, the FDIC shared losses with an acquirer on an 80/20 basis until the losses exceeded
an established threshold defined in the LSA, after which the basis for sharing losses shifted to 95/5.
Sharing losses on a 95/5 basis was eliminated for all LSAs executed after March 26, 2010.
According to the FDIC’s Web site, through May 2010, the FDIC has entered into 161 LSAs, with $173.5
billion in assets under LSAs.
Accounting for LSAs
To the extent that an institution has entered into an LSA with the FDIC, the SEC staff has requested in
comment letters that institutions consider the following when presenting the effects of the LSA in their
financial statements:
•
On the acquisition date, the LSA should be valued and recorded separately on the face of
the balance sheet, or grouped within other assets if not material, in accordance with the
indemnification guidance in ASC 805. The LSA should be subsequently reduced by either the
reimbursement of incurred losses from the guarantor or as a result of a reduction in the expected
losses from the acquired loan portfolio.
•
An institution that has elected to account for the loan portfolio under the fair value option under
ASC 825 may account for the LSA as a derivative instrument, which would be subject to the
requirements of ASC 815. The LSA would be initially recognized at fair value and subsequently
marked to fair value through earnings each reporting period, which may create volatility in
earnings.
•
The assets covered by the LSA should be recorded in their respective balance sheet categories
(i.e., loans, OREO, securities). It would be acceptable to have separate subheadings for “covered”
and “noncovered” assets.
•
The allowance for loan losses should be determined without taking into account the LSA.
•
The provision for loan losses may be net of changes in amount of receivable from the LSA, with
appropriate disclosure of the effects of the LSA on the provision.
•
Disclosures should include the assets subject to the LSA, with separate footnote disclosure about
the special nature of the assets. Alternatively, these assets should be presented separately within
Industry Guide 3 disclosures. Further, the nature, extent, and impact of the LSA need to be fully
discussed in MD&A.
The FDIC has also issued guidance on the accounting for and examiners’ considerations of LSAs. Key
points from the FDIC’s guidance are highlighted below:
•
“LSAs are considered conditional guarantees for risk-based capital purposes due to the
contractual conditions that acquirers must meet. Accordingly, an acquiring institution may apply
a 20 percent risk weight to the guaranteed portion of assets subject to an LSA.”
•
In a bargain purchase, a gain is recorded in earnings, thereby resulting in an increase in both
GAAP equity capital and regulatory capital. Under ASC 805, “an acquiring institution’s regulatory
capital is vulnerable to retrospective adjustments made during the measurement period of up
to one year from the acquisition date.” Accordingly, “the FDIC may not fully consider a bargain
purchase gain as having the permanence necessary for a tier 1 capital component . . . until the
measurement period has ended.”
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Other Considerations
If the acquired loans are subject to accounting under ASC 310-30:
•
Subsequent decreases in expected cash flows are recorded in the income statement immediately
through adjustment to a loss accrual or valuation allowance.
•
Subsequent increases in expected cash flows of the loans accreted over their life would decrease
the value of the LSA. The decrease is accreted to income over the same period.
Regulatory Sector Supplement — Banking
Consumer Protection Update
Regulation Z — Implementing the Truth in Lending Act and the Home Ownership and
Equity Protection Act
On August 16, 2010, the Board of Governors of the Federal Reserve System (the “Federal Reserve
Board”) issued the final Regulation Z rules, which become effective on April 1, 2011. These rules are
intended to protect mortgage borrowers from unfair practices related to payments made to compensate
loan originators, including mortgage brokers and loan officers.1 The rules amend Regulation Z, which
implements the Truth in Lending Act and the Home Ownership and Equity Protection Act. Regulation Z
was established to promote the informed use of consumer credit by consumers, and it applies to loans for
personal, family, or household purposes. The results of the amendments include the following:
•
Currently, loan originators may receive compensation that is based not only on the loan
amount but also on the loan terms. When the new rules take effect, a loan originator will not
be incentivized to raise the borrowers’ loan costs by increasing the loan interest rate or points
to earn additional compensation from the lender. Loan originators can continue to receive
compensation that is based on a percentage of the loan amount, which is generally considered a
common practice.
•
Through consumer testing, the Federal Reserve Board learned that borrowers are usually not
aware of (1) the payments lenders make to loan originators and (2) the effect those payments
may have on the borrower’s total cost. Under the new rule, consumers who pay the loan
originator directly are prohibited from also paying the same loan originator indirectly through a
higher interest rate, thus paying higher loan costs than they realize.
•
The rule also prevents a loan originator from steering a consumer to complete a loan that
provides the loan originator with greater compensation than would other transactions the loan
originator could have offered to the consumer. The loan originator must demonstrate that the
consumer was presented with loan options that provide (1) the lowest interest rate, (2) no risky
features, and (3) the lowest total dollar amount of origination points or fees and discount points.
Enhanced consumer awareness is expected to allow individuals to better understand the loan options and
the loan fees and costs charged by the lender.
See the Federal Reserve Board’s August 16, 2010, press release.
1
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Regulation DD and Regulation E — Final Clarification of Overdraft Services
The Federal Reserve Board clarified the December 2008 rule, effective on January 1, 2010, under
Regulation DD (Truth in Savings Act) and the November 2009 rule, effective on July 6, 2010, under
Regulation E (Electronic Funds Transfer Act), regarding overdraft services.2
Regulation DD is intended to help consumers compare deposit accounts offered by depository institutions
through the disclosure of certain account information, such as fees, annual percentage yield, and interest
rate. The amendments to Regulation DD include (1) a requirement that aggregate fee disclosures be
provided on periodic consumer deposit account statements and (2) additional disclosure requirements
for overdraft services on periodic consumer deposit account statements for disclosure of the total dollar
amount of all fees or charges imposed on the account when there are insufficient or unavailable funds
and the account becomes overdrawn for the month; these may include daily and sustained overdraft fees
or charges.
Regulation E is intended to protect individual consumers of electronic fund transfer services by establishing
the basic rights, liabilities, and responsibilities of those consumers and of financial institutions that offer
these services. The amendments to Regulation E are as follows:
•
Financial institutions are prohibited from assessing a fee or charge on a customer’s account for
paying an ATM or one-time debit card transaction that overdraws from the account without
satisfying several requirements, including (1) notifying the consumer and (2) obtaining the
consumer’s consent to the overdraft service.
•
The prohibition of assessment of overdraft fees applies to all institutions, including those that
have a policy and practice of declining to authorize and pay any ATM or one-time debit card
transaction.
Restrictions on Gift Cards and Other Prepaid Cards
On March 23, 2010, the Federal Reserve Board published final rules to amend Regulation E.3 The objective
of the rules, which are intended to protect consumers of prepaid products from abusive practices involving
gift cards, is to control fees (e.g., inactivity fees), extend expiration dates (i.e., minimum of five years), and
require certain disclosures of terms and conditions for prepaid products such as gift certificates, store gift
cards (i.e., closed-loop gift cards), and general-use prepared cards (i.e., open-loop cards).
Closed-loop cards do not typically charge fees or have expiration dates. In addition, issuers of closed-loop
cards typically do not collect information regarding the identity of the gift card purchaser or the recipient.
The new requirements include:
•
Limits on inactivity fees — Inactivity, dormancy, or service fees cannot be imposed unless three
conditions are met: (1) there is at least a one-year period of inactivity before imposition of the
fee; (2) no more than one fee is charged per month; and (3) information regarding such fees
(e.g., what the fees are, when they might occur) is provided to the cardholder.
•
Clearly marked expiration dates — The expiration dates must be clearly printed on the card. A
gift certificate, store gift card, or general-use prepaid card may not be sold unless the expiration
date of the funds is at least five years after the original issuance date or five years after the last
load of funds.
See the Federal Reserve Board’s May 28, 2010, press release. See also Deloitte’s June 2010 @Regulatory newsletter.
2
See Regulation E, Docket No. R-1377. See also Deloitte’s April 2010 @Regulatory newsletter.
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•
Clear and conspicuous terms — All information pertinent to the gift card must be clear and
easy to understand. The information should be provided on the certificate or card and disclosed
before purchase. A toll-free telephone number and a Web site, if one is maintained, should be
displayed on the certificate or card.
The final rule is expected to help promote greater consumer awareness regarding gift cards.
Credit Update
Third Stage of Implementation of the Credit Card Act (Regulation Z)
The Credit Card Accountability, Responsibility, and Disclosure Act of 2009 (the “Credit Card Act”) became
law on May 22, 2009. The new credit card rules are designed to (1) protect consumers from unreasonable
fees and penalties from issuers and (2) increase the transparency of APR increases so that consumers can
better understand the terms and conditions of their credit lines.4 Implementation occurred in three stages.
The first stage, which went into effect on August 20, 2009, addressed advance notice of rate increases
and the time frame in which consumers have to make payments. The second stage, which focused on
interest rate increases, over-the-limit transactions, and student cards, became effective on February 22,
2010. The last stage became effective on August 22, 2010, and introduced new protections regarding
disproportionate penalty fees incurred for minor matters (such as late payments). More specifically, the
rule:
•
Prohibits credit card issuers from charging penalty fees that are (1) not reasonable or proportional
or (2) greater than the associated charges. However, the rule allows the issuer to charge fees
that represent a reasonable proportion of the costs incurred by the issuer for the violation or an
amount that is reasonable to deter the type of violation.
•
Prohibits credit card issuers from charging inactivity fees, late payment fees greater than the
amount past due, and multiple penalty fees for the same violation.
•
Mandates credit card issuers that increase an APR to (1) perform a review of changes to a
consumer’s credit risk, market conditions, and other factors at least once every six months and
(2) reduce the APR if supported by the review. The reduction of credit card rates that result from
such a review should take place within 30 days after completion of the review. Under the rule,
creditors are required to review accounts on which APRs have been increased since January 1,
2009.
Regulatory Capital
Agencies Issue Final Rule for Regulatory Capital Standards Related to Statements 166 and
167
On January 21, 2010, the federal banking and thrift regulatory agencies amended their general riskbased and advanced risk-based capital adequacy frameworks by adopting a final rule that eliminates the
exclusion of certain consolidated asset-backed commercial paper (CP) programs from risk-weighted assets.
The primary objective of the rule is to better align risk-based capital requirements with the risks of certain
exposures. As a result, the banking organizations affected by Statements 166 and 167 are generally
subject to higher risk-based regulatory capital requirements. However, the rule provides an optional
See Regulation Z, Docket No. R-1384. See also Deloitte’s March and June 2010 @Regulatory newsletters.
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transition for four quarters of the effect on risk-weighted assets and Tier 2 capital resulting from a
banking organization’s implementation of the new GAAP. The four-quarter transition applies to VIEs that
were used in securitization and structured finance transactions that occurred before the effective date
of these accounting standards. The transition mechanism consists of an optional two-quarter delay in
implementation followed by an optional two-quarter partial implementation of the effect of Statement
167 on risk-weighted assets and the allowance for loan and lease losses includable in Tier 2 capital. The
transition mechanism does not apply to the leverage capital ratio and does not cover loan participations.
Statement 166 made several changes to concepts introduced in Statement 140, such as (1) elimination
of the concept of QSPEs; (2) limiting the circumstances in which a financial asset, or portion of a financial
asset, should be derecognized when the transferor has not transferred the entire original financial asset
to an entity that is not consolidated with the transferor in the financial statements being presented, when
the transferor has continuing involvement with the transferred financial asset, or both; and (3) removal
of provisions for guaranteed mortgage securitizations to require that those securitizations be treated the
same as any other transfer of financial assets within the scope of Statement 140.
Statement 167 introduced additional clarifications regarding financial reporting for reporting entities
with VIEs, such as (1) requirements for a reporting entity to perform an analysis to determine whether
its variable interest or interests give it a controlling financial interest in a VIE, (2) ongoing reassessments
of whether the reporting entity is the primary beneficiary of a VIE, and (3) elimination of the quantitative
approach previously required for determining the primary beneficiary of a VIE.
Statements 166 and 167 increased the amount of information and disclosures regarding QSPEs, transfers
of financial assets, and VIEs. In addition, these standards were designed to align existing financial
reporting requirements with those mandated by IFRSs.5
Risk Management and Governance
Federal Banking Agencies Issue Policy Statement on Funding and Liquidity Risk
Management
The “Interagency Policy Statement on Funding and Liquidity Risk Management” (“policy statement”)
was issued to provide consistent interagency expectations on sound practices for managing funding and
liquidity risk and to ensure consistency with the “Principles for Sound Liquidity Risk Management and
Supervision” issued by the Basel Committee on Banking Supervision (the “Basel Committee”) in 2008.
According to the policy statement, liquidity risk is the risk that an institution’s financial condition or overall
safety and soundness are adversely affected by an inability to meet its obligations. In drafting the policy
statement, the regulators noted that “[d]eficiencies include insufficient holdings of liquid assets, funding
risky or illiquid asset portfolios with potentially volatile short-term liabilities, and a lack of meaningful cash
flow projections with liquidity contingency plans.”
The policy statement is designed to ensure that an institution’s liquidity management processes are
adequate to meet its daily funding needs and cover both expected and unexpected departures from
normal operations. This includes maintaining adequate processes for identifying, measuring, monitoring,
and controlling liquidity risk. The Federal Reserve Board’s January 21, 2010, press release notes that in
the policy statement, the regulators outlined key elements of liquidity risk management, including the
following:
•
Effective corporate governance consisting of oversight by the board of directors and active
involvement by management in an institution’s control of liquidity risk.
See the Federal Reserve Board’s January 21, 2010, press release.
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•
Appropriate strategies, policies, procedures, and limits used to manage and mitigate liquidity
risk.
•
Comprehensive liquidity risk measurement and monitoring systems (including assessments of
the current and prospective cash flows or sources and uses of funds) that are commensurate
with the complexity and business activities of the institution.
•
Active management of intraday liquidity and collateral.
•
An appropriately diverse mix of existing and potential future funding sources.
•
Adequate levels of highly liquid marketable securities free of legal, regulatory, or operational
impediments, that can be used to meet liquidity needs in stressful situations.
•
Comprehensive contingency funding plans (CFPs) that sufficiently address potential adverse
liquidity events and emergency cash flow requirements.
•
Internal controls and internal audit processes sufficient to determine the adequacy of the
institution’s liquidity risk management process.
Principles for Enhancing Corporate Governance Issued by the Basel Committee
On March 16, 2010, the Basel Committee issued for consultation the Principles for Enhancing Corporate
Governance, a set of 14 principles designed to improve bank corporate governance, which are
summarized in the following table (reprinted from the principles):
Topic
Principle
Summary of Principle
Board practices
1
The board has overall responsibility for the bank, including approving and overseeing
the implementation of the bank’s strategic objectives, risk strategy, corporate
governance and corporate values. The board is also responsible for providing oversight
of senior management.
Board qualifications
2
Board members should be and remain qualified . . . for their positions. They should
have a clear understanding of their role in corporate governance and be able to exercise
sound and objective judgment.
Board’s own
practices and
structure
3
The board should define appropriate governance practices for its own work and have
in place the means to ensure such practices are followed and periodically reviewed for
improvement.
Group structures
4
In a group structure, the board of the parent company has the overall responsibility
for adequate corporate governance across the group and ensuring that there are
governance policies and mechanisms appropriate to the structure, business and risks of
the group and its entities.
Senior management
5
Under the direction of the board, senior management should ensure that the bank’s
activities are consistent with the business strategy, risk tolerance/appetite and policies
approved by the board.
Risk management
and internal controls
6
Banks should have an independent risk management function . . . with sufficient
authority, stature, independence, resources and access to the board.
7
Risks should be identified and monitored on an ongoing firm-wide and individual
entity basis, and the sophistication of the bank’s risk management and internal control
infrastructures should [be consistent] with any changes to the bank’s risk profile.
8
Effective risk management requires robust internal communication within the bank
about risk, both across the organisation and through reporting to the board and senior
management.
9
The board and senior management should effectively utilise the work conducted by
internal audit functions, external auditors and internal control functions.
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Topic
Compensation
Complex or opaque
corporate structures
Disclosure and
transparency
Principle
Summary of Principle
10
The board should actively oversee the compensation system’s design and operation,
and should monitor and review the compensation system to ensure that it operates as
intended.
11
An employee’s compensation should be effectively aligned with prudent risk taking:
compensation should be adjusted for all types of risk; compensation outcomes should
be symmetric with risk outcomes; compensation payout schedules should be sensitive
to the time horizon of risks.
12
The board and senior management should know and understand the bank’s
operational structure and the risks that it poses.
13
Where a bank operates through special-purpose or related structures . . . that impede
transparency or do not meet international banking standards, its board and senior
management should understand the purpose, structure and unique risks of these
operations.
14
The governance of the bank should be adequately transparent to its shareholders,
depositors, other relevant stakeholders and market participants.
SAFE Act — Final Rule
Beginning in 2011, the Secure and Fair Enforcement for Mortgage Licensing Act (the “SAFE Act”) requires
residential mortgage loan originators who are employees of agency-regulated institutions to be registered
with the Nationwide Mortgage Licensing System and Registry (the “Registry”). The SAFE Act requires that
each residential mortgage loan originator obtain a unique identifier from the Registry that will remain with
that residential mortgage loan originator, regardless of changes in employment. Registered mortgage loan
originators and agency-regulated institutions must provide these unique identifiers to consumers so that
consumers can get background information about the originator if they wish.
Agency-regulated institutions6 are also required to mandate their employees who are mortgage loan
originators to (1) comply with the requirements of this rule and (2) implement written policies and
procedures to ensure compliance with the registration requirements.
Amendments to Regulation SHO
In February 2010, the SEC adopted Rule 201 of Regulation SHO (also known as the “alternative uptick
rule”).7 The objective of the rule is to restrict short selling on a given stock that is experiencing significant
downturn in the market and to promote market stability and investor confidence. The rule only applies to
the short selling of securities (both OTC and exchange-listed) that have declined in price by 10 percent or
more from the previous market closing price.
Under the rule, a “circuit breaker” will be triggered when a stock price declines 10 percent or more from
the previous day’s closing price. The restriction may also be in effect on the following trading day. Short
selling will only be permitted at prices at or above the national best bid for such securities. The objective is
to allow long sellers to stand in front of short sellers in an effort to alleviate rapid downward pressure on
the stock.
The Federal Register notice explains that agency-regulated institutions are national and state banks, savings associations, and their applicable
subsidiaries; credit unions; Farm Credit System institutions; branches and agencies of foreign banks; and certain other foreign entities.
6
SEC Final Rule Release No. 34-61595, Amendments to Regulation SHO.
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Trading centers will be responsible for establishing, maintaining, and enforcing written policies and
procedures that are reasonably designed to prevent the execution or display of a short sale in violation of
the rule. A broker-dealer’s written procedures should, at a minimum, include procedures to monitor, in
real time, the national best bid price to ensure that any short sale orders submitted to a trading center are
in compliance with the rule’s requirements.
The rule became effective on May 10, 2010, with compliance required by November 10, 2010.
FINRA Rule 4110 — Capital Compliance
FINRA Rule 41108 became effective on February 8, 2010. The main objectives of the rule are to support
Rule 15c3-1 of the Exchange Act and to identify and monitor the financial and operational condition of
broker-dealers facing financial difficulty. Because this rule is based largely on former NASD and NYSE rules
(with some additional enhancements), it mainly affects previous NASD-only members.
Rule 4110 is divided into five main sections:
1. FINRA Rule 4110(a) — Authority to Increase Capital Compliance
Under this subsection, FINRA has the authority to require a broker-dealer to increase its net capital as
needed to protect the investing public. Increased net capital requirements could include additional
“haircuts” on certain positions (i.e., the percentage by which an asset’s market value is reduced in the
calculation of a broker-dealer’s capital requirement) or requirements that a firm treat certain assets
as nonallowable in performing its net capital computation (in accordance with Rule 15c3-1). The
requirements do not apply to introducing (nonclearing) broker-dealers. Also, once FINRA has informed
a firm that its net capital requirements have increased, the firm has the right to request an expedited
hearing. FINRA expects to exercise this authority only in limited circumstances.
2. FINRA Rule 4110(b)(1) — Suspension of Business Operations
This portion of the rule is based on former NASD Rule 3130(e) and requires any firm that is not in
compliance with Rule 15c3-1 to suspend business operations.
3. FINRA Rule 4110(c) — Withdrawal of Equity Capital
Under this portion of the rule, no member firm may withdraw equity capital for one year from the date
it was contributed, unless FINRA gives the firm written permission to do so. In addition, although Rule
4110(c)(2) states that “members are not precluded from withdrawing profits earned,” restrictions are
placed on the size and frequency of these withdrawals. Moreover, dividend payments or like distributions,
as well as unsecured loans or advances to any affiliated person or entity in which the total net withdrawals
exceed 10 percent of the firm’s excess net capital within a 35-day period, are not permitted without
FINRA’s prior written approval. Again, this provision does not apply to introducing brokers.
For more information, see FINRA’s Regulatory Notice 09-71, Financial Responsibility, issued in December 2009.
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4. FINRA Rule 4110(d)(1)(A) — Sale-and-Leaseback Transactions, Factoring, Financing,
Loans, and Similar Arrangements
This portion of the rule is based on former NYSE Rule 328(a) and requires that member firms obtain
prior written approval from FINRA before entering into a sale-and-leaseback arrangement with any of
their assets or a financing or factoring arrangement with any unsecured accounts receivable that would
increase tentative net capital by 10 percent or more. This section also stipulates that no member may
enter into an arrangement to sell or factor customer debit balances, regardless of the amount, without
prior written approval from FINRA.
5. FINRA Rule 4110(e) — Subordinated Loans, Notes Collateralized by Securities, and
Capital Borrowings
FINRA Rule 4110(e) is partly based on former NYSE Rule 420. Rule 4110(e)(1) implements Appendix D of
Rule 15c3-1, which requires that all subordinated loans be approved by the examining authority before
becoming effective. Rule 4110(e)(2) requires that the loan agreement have specific provisions, including a
minimum duration of 12 months.
Master and Sub-Account Guidance
In April 2010, FINRA issued guidance on master and sub-account arrangements.9 To comply with FINRA
rules and federal securities laws, firms may be required to recognize certain sub-accounts as separate
customers.
Determination of how an account should be classified depends on the beneficial owners and the nature
of the account. One beneficial owner may maintain multiple sub-accounts to facilitate various trading
strategies. If an investment adviser or introducing broker has a master account that maintains multiple
sub-accounts and identifies the different beneficial owners, those accounts must be treated as separate
customer accounts.
There are circumstances (e.g., with bona fide investment advisers and omnibus clearing arrangements) in
which the broker-dealer would not be privy to the identity of the beneficial owners. In these instances,
FINRA generally allows the broker-dealer to rely on the information supplied to it to determine (1) the
appropriate treatment of the master and sub-accounts and (2) whether there is more than one beneficial
owner.
If the broker-dealer is aware (or has reason to believe) that sub-accounts have different beneficial owners
but does not know the owners’ identities, the broker-dealer must investigate the beneficial ownership of
each account. Some bases for inquiry into the beneficial ownership of sub-accounts include:
•
Sub-accounts receive separate reports from the broker-dealer.
•
Sub-accounts are treated separately for tax purposes or other reporting.
•
The commission charges for an individual sub-account are incurred separately and are based on
the activity only of that particular sub-account.
•
Numerous sub-accounts are maintained for one master account.
Although this list is not all-inclusive, it contains items that might raise a “red flag” that certain
sub-accounts may have different beneficial owners. Once the broker-dealer identifies the beneficial
owners of the sub-accounts, it must treat the sub-accounts as separate customer accounts.
For more information, see FINRA’s Regulatory Notice 10-18, Master Accounts and Sub-Accounts, issued in April 2010.
9
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Regulatory Sector Supplement — Securities
Effect of Custody Rule on Broker-Dealers
On December 30, 2009, the SEC adopted amendments10 to the custody requirements of Rule 206(4)-2
under the Investment Advisers Act (the “Custody Rule”). This regulation applies when the assets
of advisory clients are in the custody of an adviser or related broker-dealer rather than held by an
independent qualified custodian. The objective of these amendments was to increase the protection
of customers whose securities and investments are in the custody of registered investment advisers by
focusing on internal control risks associated with affiliated custody, which may be greater than those
associated with independent custody.
The Custody Rule applies to SEC registered investment advisers that have advisory client funds or securities
in their custody. Custody is defined as holding client funds or securities, directly or indirectly, or having
any authority or ability to obtain possession of client funds or securities. An adviser is also considered to
have custody if a related person meets these requirements. The rule defines a related person as a person
directly or indirectly controlling or controlled by the adviser and any person under common control with
the adviser.
The Custody Rule will affect any broker-dealer that either is a registered investment adviser or is
considered to be a related person and serves as a qualified custodian for the registered investment adviser.
The main effects on such a broker-dealer include:
•
Surprise custody examinations.
•
Internal control report.
•
Quarterly account statements.
Broker-dealers that are registered investment advisers or are acting as qualified custodians for related
investments are subject to surprise examinations by an independent certified public accounting firm that
is registered with the PCAOB.11 The accountant’s procedures should include confirmation of the client’s
funds and securities with both the qualified custodian and the client on a sample basis.
In addition, broker-dealers must provide any related advisers an internal control report related to custodial
services. This report must:
•
Be obtained annually.
•
Include an opinion from an independent certified public accounting firm that is registered with
the PCAOB regarding whether:
o
Controls have been placed in operations as of a specific date.
o
The controls are suitably designed.
o
The controls meet the control objectives specified by the SEC.
o
The operation of the controls was sufficiently effective.
SEC Final Rule Release No. IA-2968, Custody of Funds or Securities of Clients by Investment Advisers.
10
The SEC issued a “no-action” letter on October 12, 2010, which provided guidance on compliance with the Annual Audit Provision of the Custody
Rule in situations in which the public accountant is registered with the PCAOB but does not perform public-company audits and therefore is not
subject to regular PCAOB inspections.
11
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The independent accountant is also required to verify that the funds and securities are reconciled to a
custodian other than the adviser or its related persons (e.g., Depository Trust Corporation).
The internal control report must be maintained in the investment adviser’s records for five years from the
end of the fiscal year in which the report is finalized.
Broker-dealers acting as qualified custodians for registered investment advisers must send account
statements to the clients at least quarterly. The registered investment adviser is required to perform
“due inquiry” and obtain a reasonable belief that the account statements are being sent by the qualified
custodian. This due inquiry may include obtaining a copy of a customer statement that was sent to a
particular customer.
Registered advisers that are also acting as introducing brokers, or that have related parties acting
as introducing brokers for their clients, should also consider the following (as noted in the SEC staff
responses to questions about the Custody Rule):
•
Introducing brokers that are dually registered and that have the ability to receive cash or
securities are subject to the internal control report requirement.
•
If the introducing broker is an affiliate of the adviser and has the ability to receive cash or
securities, it is considered a qualified custodian and is subject to the internal control report
requirement. The adviser is then subject to the surprise examination requirement.
•
Additional monitoring should be performed to assess whether the introducing broker has
the ability to move funds at the clearing broker on behalf of the adviser’s clients; if so, the
introducing broker may be subject to the internal control report requirement.
The SEC is reviewing proposals of enhancements to the oversight of broker-dealer custody of customer
assets, so additional custody rules on this topic may be proposed.
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107
Section 6
Insurance Sector Supplement
Insurance Accounting Update
This section discusses recent accounting developments that are of specific interest to insurance
companies. It should be read in conjunction with Sections 1 and 2, which address other key accounting
considerations that have broader applicability to financial services entities and may also be relevant to the
insurance sector.
FASB Issues Discussion Paper on Insurance Contracts
In August 2010, the FASB issued a DP, Preliminary Views on Insurance Contracts. The DP gives constituents
the opportunity to comment on an insurance accounting model proposed by the IASB in its ED, Insurance
Contracts, that, if adopted in the United States, would result in sweeping changes to the existing U.S.
model. In addition, the DP summarizes the ED’s key provisions, indicates the FASB’s preliminary views, and
includes an appendix with a table comparing current U.S. GAAP with the (1) ED’s proposed model and (2)
FASB’s preliminary views.
Although the FASB and IASB have expressed a desire to develop high-quality, compatible insurance
accounting standards and have undertaken this project as a joint project, insurance accounting is not
one of the projects addressed in the Memorandum of Understanding between the two boards, and
there is no specific timeline for issuing a converged standard (although the IASB has stated its intent to
issue a final revised version of IFRS 4 in the second quarter of 2011). Moreover, the FASB’s preliminary
views differ from the views expressed in the ED in a number of important respects. Accordingly, the FASB
chose to issue a DP instead of an ED to solicit input “on the advantages and disadvantages of pursuing a
comprehensive reconsideration of insurance accounting versus making targeted improvements to current
U.S. GAAP.” The DP does not incorporate the ED but refers to it extensively.
Scope
Both the FASB and IASB agreed that an insurance contract is defined as a “contract under which one
party (the insurer) accepts significant insurance risk from another party (the policyholder) by agreeing to
compensate the policyholder if a specified uncertain future event (the insured event) adversely affects
the policyholder.” Thus, the application of insurance accounting does not depend on whether the entity
writing the contract is an insurance company.
The FASB did not agree with the IASB’s belief that financial instruments with discretionary participation
features should be within the ED’s scope and questioned whether employer-provided health insurance
(from the perspective of the employer) “should be excluded from the scope of the proposed guidance for
U.S. GAAP.”
The reasons cited in the FASB’s DP for the FASB’s preliminary conclusion that financial instruments with
discretionary participation features should be excluded from the project’s scope include:
Section 6: Insurance Sector Supplement
•
They do not transfer significant risk to the insurer and therefore do not meet the definition
of an insurance contract. Applying insurance accounting to such contracts creates additional
complexities, such as a need to separate these contracts from other investment contracts and to
identify a separate principle for contract boundary.
•
The model may end up becoming an industry-specific model, since insurance companies have
significant volume in these non-insurance-type arrangements.
•
Other financial institutions account for these contracts as financial instruments, which may lead
to comparability issues.
108
The DP does not specify whether employer-provided health insurance should be included within its scope
but requests feedback from constituents on this matter. It observes that providers of such insurance may
receive premium payments through salary deductions and indicates that some believe such arrangements
should be accounted for as insurance and others believe they are employee compensation expense. The
DP also noted stakeholder uncertainty regarding possible effects of the recent health care reform law.
Measurement Models
According to the FASB’s preliminary views, entities would use a measurement model consisting of a
single composite margin that defers profit at inception and implicitly reflects risk and uncertainty in the
fulfillment cash flows. The Board believes that this approach is preferable to the IASB’s model, in which
explicit risk adjustment and residual margins are used. Under both views, losses at inception (i.e., “onerous
contracts”) would be recognized immediately in earnings. The DP refers to these measurement models as
the single (i.e., “composite”) and two-margin approaches.
Unless the contract is onerous, no measurement differences exist at inception because, under both
approaches, the residual margin and composite margin are calibrated to the consideration received or
receivable from the policyholder to avoid day 1 gains. However, day 2 and beyond would yield differences
in measurement. For contracts not qualifying for the IASB’s modified approach (long-duration contracts),
the IASB risk adjustment margin is remeasured in each reporting period, with changes recognized in
earnings, and the residual margin (which is fixed at inception) is recognized systematically over the
coverage period. In contrast, under the FASB’s approach, the composite margin is not discounted; it is
fixed at inception and recognized in earnings over the coverage and claims handling period. Amortization
of the composite margin is based on the ratio of premiums and claims cash flows allocated and paid
to date to those ultimately expected. In addition, unlike the two-margin approach, in which interest is
accreted on the risk and residual margins, the composite margin approach would not accrete interest.
Measurement under the IASB’s modified approach for short-duration contracts would also differ from that
under the FASB’s approach. These differences are discussed in greater detail below.
Acquisition Costs
The FASB and IASB agree that incremental acquisition costs (i.e., “those costs that would not have been
incurred if the insurer had not issued that particular contract”) identified at the individual contract level
would be included in the unbiased probability-weighted net fulfillment cash flows (“net cash flows”)
and would reduce the profit within the residual margin (or composite margin). They further agree that
acquisition costs that are not incremental would be expensed as incurred.
However, the DP observes that differences may arise between the types of acquisition costs that may be
included in net cash flows under the proposed building-blocks approach and those that could be deferred
under U.S. GAAP under the recent final consensus reached by the EITF on Issue 09-G. Issue 09-G aligns
the accounting for acquisition costs with the accounting for loan origination costs. Thus, Issue 09-G
indicates that only the following costs may be deferred and only as they relate to successful contracts:
(1) incremental direct costs and (2) the portion of an employee’s total compensation and payroll-related
fringe benefits directly related to time spent on successful contract acquisition activities. In addition, Issue
09-G specifies that direct-response advertising costs may be included in acquisition costs to the extent
that they meet the capitalization criteria in ASC 340.
The ED differs from Issue 09-G regarding employee costs. Specifically, the ED allows an entity to include
commissions paid to employees for policy issuances as acquisition costs in net cash flows. Issue 09-G,
however, treats commissions paid to employees for successful policy issuances as part of the total
compensation subject to allocation on the basis of time spent on contract acquisition activities. In
addition, under the ED, all advertising costs are expensed.
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Modified Approach for Short-Duration Contracts
The ED requires a modified approach for short-duration contracts. This approach applies to contracts
for which (1) the period of coverage “is approximately one year or less” and (2) the “contract does not
contain embedded options or other derivatives that significantly affect the variability of cash flows, after
unbundling any embedded derivatives.”
The ED distinguishes between a pre-claims liability and a pre-claims obligation. Under the modified
approach, the insurer recognizes a pre-claims liability representing its stand-ready obligation to pay valid
claims (the pre-claims liability) as well as a claims liability for valid claims for insured events that have
already occurred, including those that are incurred but not reported (the post-claims liability). In the ED,
this pre-claims liability is defined as “the preclaims obligation less the expected present value of future
premiums, if any, that are within the boundary of the existing contract.” The pre-claims obligation is
measured at inception as the amount of premium received and the present value of future premium
cash flows net of incremental acquisition costs, and is subsequently allocated to earnings over the
coverage period in a systematic way. Thus, the pre-claims liability is the amount of premium received net
of incremental acquisition costs as well as allocated premiums. Further, the ED requires that a current
discount rate be used to accrete interest on the carrying amount of the preclaims liability.
Like all other insurance liabilities, the postclaims liability is measured as the present value of fulfillment
cash flows. For contracts accounted for under the modified approach, an insurer would separately present
premium revenue, claims and expenses incurred, and amortization of incremental acquisition costs in the
performance statement.
While certain FASB board members believe that a modified approach should apply to some insurance
contracts, the FASB has not concluded on the extent to which, or conditions in which, it would apply. In
addition, the FASB does not express any preliminary views on this subject in the DP and asks respondents
for their thoughts on this matter.
Transition
The ED indicates that at transition, insurers would need to restate their ending insurance contract liabilities
at the beginning of the earliest year presented through a series of adjustments that include:
•
Write-off to opening retained earnings of all insurance intangible assets, such as deferred
acquisition costs or intangible assets recognized upon acquisition of insurance businesses and
portfolios.
•
Use of the building-blocks approach to restate all of the in-force insurance contracts. Any positive
or negative difference arising from this restatement would need to be recognized in opening
retained earnings. No residual margin would be recognized on transition.
Comments on the ED are due to the FASB by December 15, 2010, unless a respondent would have liked
to participate in one of the roundtable discussions planned for December 2010, in which case comments
were due by November 30, 2010.
Accounting for Costs Associated With Acquiring or Renewing Insurance Contracts
(EITF Issue 09-G)
Insurance entities that apply the industry-specific guidance in ASC 944-30 defer and subsequently
amortize certain acquisition costs incurred during the acquisition of new or renewal contracts. Such costs
are commonly referred to as deferred acquisition costs (DAC). This Issue addresses the current diversity in
the types of costs entities included in DAC.
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ASC 944-30-20 defines acquisition costs as those “incurred in the acquisition of new and renewal
insurance contracts. Acquisition costs include those costs that vary with and are primarily related to the
acquisition of insurance contracts.”
While ASC 944-30 gives several examples of costs that would meet the definition of acquisition costs,
the definition itself is very broad and has led to diversity in practice. The examples in ASC 944-30-55-1
are agent and broker commissions, salaries of certain employees involved in the underwriting and policy
issuance functions, and medical and inspection fees.
At its September 2010 meeting, the Task Force “reached a final consensus that incremental direct
costs of contract acquisition that are incurred in transactions with both independent third parties and
employees are deferrable in their entirety.” As a result, the Task Force’s final consensus would allow for
the capitalization of the following costs that are incurred in the successful acquisition of new and renewal
insurance contracts:
•
Incremental direct costs of contract acquisition. Incremental direct costs are costs that result
directly from and are essential to the acquisition of the contract and that the entity would not
have incurred had that contract transaction not occurred (e.g., commissions to third parties or
employees).
•
Certain costs that are directly related to the following acquisition activities performed by the
insurer for the contract:
o
Underwriting.
o
Policy issuance and processing.
o
Medical and inspection.
o
Sales force contract selling.
The costs related to such activities include (1) only a portion of an employee’s fixed compensation
and payroll-related fringe benefits directly related to time spent performing such activities for
actual acquired contracts and (2) other costs directly related to those activities that would not
have been incurred if the contract had not been acquired.
•
Advertising costs should be included in DAC only if the capitalization criteria for direct-response
advertising in ASC 340-20 are met. However, direct-response advertising costs capitalized will be
included in DAC and will be subject to the guidance in ASC 944 on subsequent measurement and
impairment (premium deficiency).
This Issue will be effective for fiscal years (and interim periods within those fiscal years) beginning after
December 15, 2011. Early application will be permitted. At its September 29, 2010, meeting, the Board
ratified the consensus reached by the Task Force for this Issue.
Consideration of an Insurer’s Accounting for Majority Owned Investments When
the Ownership Is Through a Separate Account (EITF Issue 09-B)
An insurance company often establishes separate accounts that legally protect the contract holder’s
assets from the company’s general creditors. The contract holders (insured individual or organization)
typically are given several investment options to choose from (e.g., mutual funds). While the contract
holders control all investment allocation decisions and are entitled to all returns on the investments (less a
management fee paid to the insurance company), the insurance company typically has the ability to vote
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111
any shares on behalf of the contract holders. The insurance company may also have direct investments in
these same investment funds through interests held in its general account.
Under ASC 944-80, the insurance company is required to measure the investments within its separate
accounts at fair value and present these amounts as summary totals, apart from the general accounts of
the insurance company, on the face of the consolidated statement of financial position if certain criteria
are met (listed in ASC 944-80-25-3). The predominant current practice is for insurance companies not to
fully consolidate an investment fund unless the insurance company’s general account has a direct majority
interest in the investment fund (e.g., a direct interest of more than 50 percent). However, in practice,
insurance companies often proportionately consolidate any direct investment in an investment fund
(through the general accounts) if a majority interest in that investment fund is held in combination by both
the general and separate accounts.
The Task Force deliberated the following issues in relation to this topic:
•
Whether an insurance company should fully consolidate an investment fund when a majority
interest is held by the separate accounts or through a combination of its separate accounts and
general accounts.
•
If the insurance company consolidates an investment fund under this Issue, how the consolidated
mutual fund should be reflected in the financial statements of the insurer.
The Task Force decided that an insurer is not required to combine its general account interest with any
separate account interests when assessing whether the insurer has a controlling financial interest in an
entity that is not a VIE. Thus, an insurance company would not be required to consolidate an investment
fund that is not a VIE that is controlled by the separate accounts or through a combination of interests
held by the general and separate accounts.
The Task Force also reached a final consensus to expand the scope of this Issue to provide guidance on
how interest held by a separate account in an investment fund will affect the consolidation assessment
under Statement 167’s amendments to ASC 810-10 (as amended by ASU 2009-17). The Task Force
expanded the application of the principle and concluded that in evaluating whether the investment fund is
a VIE and the insurance entity is the primary beneficiary, the insurance entity should not consider interests
held through the separate accounts.
The Task Force also discussed whether additional guidance is needed on how an insurance entity should
consolidate an investment fund in which the insurance entity owns a controlling financial interest and the
separate account holders and unrelated third parties also hold equity interests. The Task Force reached a
final consensus that an insurance entity should consolidate the investment fund by including the portion
of the fund’s assets that represent the contract holder’s interest as separate account assets and the
remaining portion of the fund assets, including the portion related to noncontrolling interests, in the
general account of the insurance entity. An insurance entity would also record a corresponding liability
for the separate account assets, and the portion related to noncontrolling interest would be included as a
noncontrolling interest in the equity of the insurance entity, if the equity classification criteria are met.
This Issue was ratified and is effective for interim and annual periods beginning after December 15, 2010,
and should be applied retrospectively to all prior periods. Early application is permitted.
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112
Regulatory Sector Supplement — Insurance
Regulators Vet Issue of Retained Asset Accounts
Reacting to a media blitz in recent months about the long-held practice of death benefit payment options,
the NAIC took steps to improve the disclosure process at its 2010 Summer National Meeting in Seattle.
Forming a special committee to examine the subject of RAAs, regulators in the NAIC’s new Retained Asset
Accounts Working Group met to review a practice, which has existed since the 1980s, that allows insurers
to maintain life insurance policy payouts in interest-bearing, general corporate accounts while distributing
the proceeds to beneficiaries through a bank-draft-type system linked to low-interest accounts maintained
in the respective beneficiary’s name.
At the Retained Asset Accounts Working Group’s August 15, 2010, meeting, ACLI Senior Vice President
Insurance Regulation & Chief Actuary Paul Graham made it clear that, contrary to what media reports
have stated, he believes RAAs help beneficiaries by allowing them to postpone making significant financial
decisions.
“[RAAs] provide the benefit of time,” Mr. Graham said. “They allow grieving beneficiaries to make financial
decisions at the time they choose to make them, while providing interest income that compares favorably
with many other on-demand deposits while that time elapses.”
A July 2010 report in Bloomberg Markets magazine created a firestorm among public officials, who took
issue with the practice that has insurers holding and investing approximately $28 billion owed to one
million beneficiaries.
In an August 2010 press release, the NAIC noted, “We know there have been relatively few consumer
complaints about RAAs, but it is our desire to make sure consumers have as many choices as possible
and that all payment term options are easy to understand,” New Hampshire Insurance Commissioner and
Retained Asset Accounts Working Group Co-Chairman Roger Sevigny said in a statement. Connecticut
Insurance Commissioner and Retained Asset Accounts Working Group Co-Chairman Thomas Sullivan
also indicated that “[they] intend to make sure consumers have appropriate disclosure surrounding these
benefits.”
Although the Retained Asset Accounts Working Group took no official action at the meeting, on the day
the working group met, the NAIC released a Consumer Alert that outlines options the public might take if
offered the option of an RAA in lieu of a single payment of a death benefit.
At its 2010 Fall National Meeting in Orlando, the NAIC continued to work on laying the ground rules for
insurers’ treatment of RAAs. At a meeting of the Retained Asset Accounts Working Group, regulators
discussed the creation of a model bulletin that could include new mandates and disclosure requirements
for RAAs.
The working group discussed the results of a survey of RAA disclosure and claim forms from 13
companies. The forms were compared to the effective practices outlined in the NAIC’s Retained Asset
Accounts Sample Bulletin, which dates to 1993.
The findings of the survey revealed several areas where disclosures could be unclear, including:
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•
The portrayal of RAAs as “checkbooks” rather than draft accounts.
•
Failure to indicate where the proceeds are kept (at a bank or kept in a company’s general
account).
113
•
Failure to indicate the interest rate to be earned in the initial disclosure form.
•
Failure to clarify whether the funds are FDIC insured.
•
Failure to reference the protection of guaranty fund coverage, when applicable.
In addition, it was noted that disclosure forms vary widely in length between insurers, and that additional
disclosures may be needed regarding the proceeds exceeding FDIC and guaranty fund coverage.
Moving ahead, the Retained Asset Accounts Working Group has charged its subgroup to modify the NAIC
RAAs Sample Bulletin in light of the survey findings. In addition, the subgroup has also been tasked with
arriving at suggested language regarding the filing of RAA disclosures with state insurance regulators.
Solvency Modernization Initiative Roadmap Advances
During the NAIC’s 2010 Summer National Meeting, the NAIC Solvency Modernization Initiative (SMI) Task
Force took strides toward examining the current state of the insurance solvency regulatory regime by
issuing an updated SMI Roadmap. The SMI Roadmap is a concrete work plan that (1) tracks the progress
of groups within the NAIC that focus on key topics ranging from capital requirements to governance
and risk management, (2) gives an overall view of progress made, and (3) sets benchmarks for short- and
long-term goals.
In an NAIC press release about the SMI Roadmap, Arizona Insurance Director Christina Urias, who chairs
the SMI Task Force, stated, “This new version of the roadmap builds on the task force’s considerable
research on solvency structures from all over the world.”
The SMI kicked off in June 2008, when regulators embarked on a critical self-examination of the U.S.
insurance solvency regulation framework. The aim of the SMI was to include a review of international
developments in insurance supervision, banking supervision, and international accounting standards as
well as their potential use in the United States. The study identified five key areas for further investigation:
Section 6: Insurance Sector Supplement
•
Capital requirements — Regulators are conducting a holistic evaluation of risk-based capital
formulas, factors, and methods and considerations related to additional capital assessments.
•
Governance and risk management — Regulators will evaluate the existing U.S. laws, study
international corporate governance principles and standards, and determine whether such
principles should be supported through a model law. Regulators will also draft a consultation
paper discussing risk management reporting and quantification requirements in light of risk
management supervisory tools being developed around the world that incorporate periodic risk
reporting, stress tests, and prospective solvency assessment.
•
Group supervision — Regulators will consider incorporating certain prudential features of group
supervision to provide a window into group operations while building upon the existing walls,
which provide solvency protection. The concepts include:
o
Communication between regulators.
o
Supervisory colleges.
o
Access to and collection of information.
o
Enforcement measures.
114
o
Group capital assessment.
o
Accreditation.
•
Statutory accounting and financial reporting — Regulators continue to analyze IASB and FASB
pronouncements, as well as IFRSs, especially regarding insurance contracts, financial instruments,
revenue recognition, and reporting.
•
Reinsurance — Regulators will provide guidance on reinsurance evaluation and possible revision
of the requirements and standards in place for a state insurance department to be NAIC
accredited. They may also consider whether the modernization of risk transfer requirements
applicable to life insurance is appropriate.
With an updated roadmap of the NAIC’s SMI approved at the NAIC’s 2010 Summer National Meeting,
highlights from the 2010 Fall National Meeting included discussion on group capital assessment and the
advancement of a draft Model Holding Company Model Act.
Regarding the topic of group capital assessment, the SMI Task Force is working to set U.S. priorities and
focus for the IAIS Common Framework for the Supervision of Internationally Active Insurance Groups
(ComFrame) project.
There has been industry discussion regarding allowing a company’s enterprise risk management or own
risk solvency assessment — which requires an insurance company to perform a risk and capital assessment
and report to the regulator — to serve as an avenue by which group capital is reviewed, rather than by a
formal group capital calculation.
Meanwhile, at a meeting of the NAIC’s Group Solvency Working Group, the working group exposed for
comment its Holding Company and Supervisory College Best Practices paper. The best practices outlined
in this document encompass a range of issues, including communications between regulators; ownership
and control as it relates to coordination of form review; and to mergers and acquisitions; standards of
management of an insurer within a holding company; and affiliated management and service agreements.
The Group Solvency Working Group also has out for comment its draft Proposal for Substantially Similar
Provisions of Revised Insurance Holding Company System Model Act and Regulation, which proposes
provisions states would be required to include in insurance holding company laws or regulations and the
safe-keeping of the types of holding company information that would be filed to regulators as outlined in
the law/regulation.
NAIC Tackles Dodd-Frank Provisions
With the Dodd-Frank Act serving as an axis for much of the activity at the NAIC’s summer 2010 meeting,
regulators used the conference to tackle some of the more time-sensitive items on their to-do list.
Surplus Lines
One key area that regulators have focused on is the provision to harmonize and streamline surplus lines
and reinsurance. Under Title IV, the Dodd-Frank Act absorbs the Nonadmitted and Reinsurance Reform
Act (NRRA) of 2010, which had not been passed in the previous two sessions of Congress. Under the
law, the home state of the insurer is given the duty of regulating the insurer and collecting taxes. After
two years, the collection and distribution of premium taxes would be handled by an interstate compact/
database that would, on the basis of data submitted by the home states, use a formula to allocate funds
back to the states accordingly. Beginning two years after the enactment date of the NRRA, states should
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115
be participating in a producer database of the NAIC or an equivalent uniform national database that is
used to license surplus lines insurers. As regulators continue to monitor the situation, the NAIC announced
at its summer 2010 meeting the establishment of a new executive-level task force that is charged with
developing a state-based solution to the federal demands, including issues related to uniform surplus-linebroker licensing and the allocation of surplus lines premium taxes across the states.
Reinsurance
The Dodd-Frank Act has partially resolved a long-waged battle by nonadmitted reinsurers over the issue
of harmonizing regulation and lowering collateral requirements. However, concerns remain about how
the new provisions will play out. At the NAIC’s 2010 Summer Meeting, regulators on the Reinsurance
Task Force discussed the issue of amending state accreditation standards to fall in line with the new law.
To that end, the task force opened for a 30-day comment period (which ended on September 16, 2010)
a draft about recommendations on key elements of the reinsurance framework to be considered for the
NAIC state accreditation program. Under NRRA, which will take effect on the one-year anniversary of
the bill signing, the domiciliary state of a reinsurer would be solely responsible for regulating the financial
solvency of the company. According to the NAIC, the Dodd-Frank Act does not appear to require singlestate licensure. For a ceding insurer to receive credit for reinsurance, the reinsurer would still need to be
licensed in the ceding insurer’s domiciliary state. The task force will consider amendments to the NAIC’s
Credit for Reinsurance Model Regulation and its Credit for Reinsurance Model Law so that they more
closely align with the NAIC’s Reinsurance Regulatory Modernization Framework Proposal. This proposal
sets up a framework of rating reinsurers and setting collateral limits based on the financial strength of
a company. Groups such as the Property Casualty Insurers Association of America generally oppose
reduction in the current collateralization requirements without provisions that would provide equivalent
credit to U.S. ceding companies.
Choosing a State Regulator to Be Appointed to the Financial Stability Oversight Council
As part of their closing business in Seattle, regulators laid out the framework by which one state insurance
commissioner will be chosen to serve a two-year, nonvoting term on the new FSOC, created under the
Dodd-Frank Act to evaluate systemic risk in companies. As the financial reform bill was being vetted,
regulators had fought for the right to be a part of the panel, and they won. Of the 10-member board,
three members will have insurance expertise, including the director of the new FIO (who has yet to be
named and who will not have voting rights), a voting member with insurance expertise, and a nonvoting
state regulator. The Dodd-Frank Act directs the NAIC to choose a sitting insurance regulator to serve a
two-year term on the FSOC board. As discussed at the NAIC’s 2010 Summer Meeting, the process will
be similar to an application for employment: it will include an invitation to apply and an explanation of
qualifications. The selection will be conducted by a committee of NAIC officers who will be charged with
making recommendations to the NAIC Executive Committee. The final choice will then be in the hands of
the full NAIC membership.
Federal Insurance Office
Although not a major focus of discussion at the NAIC’s 2010 Summer Meeting, another important piece
of the Dodd-Frank Act is the creation of the first office in the federal government that is focused on
insurance. The FIO, as established by the U.S. Department of the Treasury, will gather information about
the insurance industry, including access to affordable insurance products by minorities, low-income and
moderate-income persons, and underserved communities, and it will serve as a uniform, national voice on
insurance matters for the United States on the international stage.
Section 6: Insurance Sector Supplement
116
The FIO will also monitor the insurance industry for systemic risk purposes, with limited power to:
•
Recommend insurers that should be treated as systemically important.
•
Assist in administering the Terrorism Risk Insurance Program.
•
Represent the United States in the IAIS.
•
Determine whether state insurance measures are preempted by international agreements.
The FIO has the authority to:
•
Issue subpoenas to gather information from specific entities.
•
Conduct a study within 18 months of enactment on:
o
Costs and benefits of potential federal regulation of insurance.
o
Feasibility of regulating only certain lines at the federal level.
o
Ability to minimize regulatory arbitrage and developments in the international regulation of
insurance.
o
Ability of federal regulation to provide robust consumer protection.
o
Potential consequences of subjecting insurance companies to a federal resolution authority.
The FIO does not have supervisory power over companies. However, the FIO does have the authority
to obtain information to achieve its objectives. The potential effect on insurance companies is that they
may be required to provide information and data to the FIO that are not required today and to make
incremental changes to systems.
Regulators Offer Insurers Guidelines on STOA Transactions
The issue of STOA transactions is bubbling up to the NAIC. At the 2010 Fall National Meeting, the NAIC
Life and Annuities Committee moved to create a subgroup to develop a revised draft of the committee’s
model bulletin that encourages insurance companies to have safeguards in place to limit potential
exposure to STOA transactions. The new subgroup will be led by New Jersey Banking and Insurance
Commissioner Tom Considine and Iowa Deputy Commissioner Jim Mumford.
The current draft defines STOAs as being similar to stranger-originated life insurance transactions (STOLIs)
in that they are both driven by agents or investors who offer to pay people unknown to them a fee for
allowing the use of the person’s identity as the “measuring life” on an investment-oriented annuity. The
target individuals are usually people who are in poor health and have a life expectancy of less than one
year.
The target individuals are often solicited via newspaper advertisements and through nursing homes and
hospice care facilities. Once the person signs on, they are given certain conditions, such as a bonus rider
or a guaranteed minimum death benefit.
Practices can expand to include agents purchasing many policies from a diverse number of companies. To
avoid detection, agents will often take precautions to ensure that the dollar amount of the annuity falls
below specific underwriting guidelines. A trust or an organization may also be named as beneficiary of the
annuity to hide the true identity of those who will benefit from the annuitant’s death.
Section 6: Insurance Sector Supplement
117
As with STOLI transactions, at stake for insurance companies who unwittingly are tied to STOA
transactions are risks such as reputational risk and legal risk, among others.
Suggested guidelines for insurance companies included in the model bulletin are as follows:
•
Review chargeback policies to ensure agent commissions are adjusted if a policy is annuitized
within the first year of the contract.
•
Create detection methods to identify agents who may be involved in the facilitation of STOA
transactions.
•
Review all annuity applications to ensure specific questions are posed with regard to an
annuitant’s health status and the manner in which the contract is being funded.
•
Ensure the underwriting department has “red flags” established so questionable applications are
referred for additional review.
•
Report potential STOA transactions to the appropriate department of insurance.
Going forward, the committee will consider interested party comments that were due by October 8,
2010. Revisions of the model bulletin will follow.
Section 6: Insurance Sector Supplement
118
Section 7
Real Estate Sector Supplement
Real Estate Accounting Update
This section discusses recent accounting developments that are of specific interest to real estate
developers, owners, and operators and should be read in conjunction with Sections 1 and 2, which
address other key accounting considerations that apply more broadly to financial services entities and may
be relevant to companies in the real estate sector.
Leases
On August 17, 2010, the FASB and IASB published for public comment an ED on leases. For a number
of years, the two boards have been actively working on revising the lease accounting model to address
off-balance-sheet treatment of operating leases. Many believed that GAAP lease accounting was too
reliant on bright-line tests and offered entities the opportunity to structure arrangements to produce
a desired accounting effect, which often led entities to account for economically similar transactions
differently. Although much criticism of lease accounting was directed toward lessees’ accounting, the ED
also proposes to fundamentally change the accounting for leases by lessors.
The FASB is separately considering a project on investment properties that may cause lessors of real estate
to be outside the scope of the new lease accounting guidance (see the Investment Properties section
below for more information about this project). The proposed leasing guidance will still affect tenants
(including lessees of real estate property). Thus, as a result of changes to lessee behavior, certain business
changes and challenges may arise that could affect owners of rental properties regardless of whether they
are within the scope of the new lease accounting standard.
With limited exceptions, the ED would require that all leases be presented on the balance sheet of both
lessors and lessees. The ED has two different lessor accounting models: the performance obligation
approach and the derecognition approach. To determine which accounting model to apply, the lessor
evaluates whether it retains exposure to significant risks or benefits associated with the leased asset. If
exposure to significant risks or benefits associated with the leased asset is retained, the performance
obligation approach is used. Most real estate companies that lease property to multiple tenants are likely
to follow the performance obligation approach. Manufacturers and dealers of assets that use leasing as a
mechanism to sell the asset would typically use the derecognition approach.
Performance Obligation Approach
Under the performance obligation model, the leased asset would remain on the lessor’s books and
continue to be depreciated. The lessor would recognize (1) an asset for the right to receive lease payments
plus any recoverable initial direct costs incurred by the lessor and (2) a corresponding lease liability at the
present value of the lease payments. The underlying asset, the right to receive lease payments, and the
lease liability would be presented together in the statement of financial position, with a total for the net
lease asset or net lease liability. A lessor would amortize the lease liability to income on a straight-line basis
or by using another systematic and rational approach. The interest method would be used to recognize
interest income on the receivable, resulting in a decrease in income over the term of the lease. Lessors
would be required to reassess the expected lease payments in each reporting period and would adjust the
receivable prospectively if new facts or circumstances (e.g., revised tenant sales projections resulting in
revised expected contingent rent projections, changes in the expected lease term) indicate that there is a
significant change in the right to receive rental payments. Changes in current- and prior-period contingent
rents would be recognized in the current-period income statement, while changes in future contingent
rents would result in adjustments to the recorded asset and obligation. All changes in expected lease
terms are adjusted with respect to the lease asset and lease liability.
Section 7: Real Estate Sector Supplement 119
Under the performance obligation approach, rental income (which is typically recognized on a straightline basis under the current model) would be replaced by (1) interest income on the receivable (declining
as the receivable balance is reduced) and (2) lease income as the lease performance obligation liability
is satisfied (typically on a straight-line basis) over the lease term. The proposed guidance requires lessors
to present the income statement components separately, but a “net lease income” subtotal of the leaserelated amounts should be presented on the income statement. Further, under the performance obligation
approach, leases with increasing step rent payments will result in increased cash flows to lessors coupled
with decreased net rental income during the lease term. Many lessors believe this accounting result does
not accurately reflect the substance of their lease agreements with tenants.
Derecognition Approach
Under the derecognition approach, a portion of the leased asset is removed from the lessor’s books.
The lessor records (1) a receivable (and lease income) for the present value of expected rental payments
and (2) a residual asset representing the right to the underlying asset at the end of the lease term. Lease
expense would be recognized for the portion of the leased asset that is removed from the lessor’s books,
calculated as of the date of inception of the lease as follows:
Fair value of the right to receive lease payments ÷ fair value of the underlying asset
×
Carrying amount of the underlying asset
Although the lessor recognizes income and expense upon lease commencement, the amount of up-front
profit (or loss) recognized may be different from that recognized under a sales-type lease under current
U.S. GAAP. This is due to the ED’s guidance related to contingent rentals, residual value guarantees,
and other elements of lease contracts (including the calculation of the residual asset), which differ from
current guidance. The lessor would use the interest method to amortize the receivable and recognize
interest income. As of each reporting date, the lessor would reassess its expected lease payments if new
facts or circumstances indicate a significant change in the right to receive lease payments. This model
is expected to be used primarily by manufacturers, dealers, and banks that use leases as a mechanism
to sell assets or to earn financing income; in most cases it will not apply to real estate companies with
multitenant properties.
Investment Properties
The FASB has announced a project to converge the guidance on investment properties under U.S. GAAP
with IAS. Under this project, the Board is considering whether entities should be given the option (or
be required) to measure an investment property at fair value through earnings. IAS 40 provides such an
option. The project may include its own lease accounting model, which an entity would use when it
carries its investment properties at fair value. As a result, investment properties accounted for at fair value
could be outside the scope of the new lease guidance.
The FASB’s definition of an investment company was originally expected to be generally consistent with
that under IAS 40, which states that “property (land or a building — or part of a building — or both) held
(by the owner or by the lessee under a finance lease) to earn rentals or for capital appreciation or both,
rather than for: (a) use in the production or supply of goods or services or for administrative purposes; or
(b) sale in the ordinary course of business.” However, the FASB has indicated that it believes that the fair
value measurement provisions for investment property should be required (rather than optional as under
IAS 40).
Section 7: Real Estate Sector Supplement 120
The FASB has been conducting outreach recently to various constituents to better understand which
entities would be affected by the potential investment property guidance and whether certain entities or
properties should be excluded from the fair value measurement requirement. The outreach results have
been mixed, with some constituents in support of a requirement to measure investment property at fair
value (believing that it is the most relevant measurement attribute) and others opposed to it. Constituents
cited concerns about (1) the relevance of a fair value measurement when reporting entities do not intend
to sell the property, (2) the cost and effort involved in developing a fair value measurement, and (3) the
potential for earnings volatility that will not be realized. The Board has asked the staff to consider whether
there are alternative ways to define the scope the investment property project.
Under IAS 40, owner-occupied property is not considered investment property. When evaluating whether
an asset is owner-occupied or investment property, entities must consider the significance of ancillary
services provided to the tenants of the property. If ancillary services are an insignificant component of
the arrangement as a whole (e.g., the building owner supplies security and maintenance services to the
lessees), then the entity may treat the property as investment property. However, when the ancillary
services provided are significant (such as those provided at a hotel or certain health care properties), the
property would be classified as owner-occupied and thus would not be considered investment property.
As a result, some real estate owners could be required to measure some of their real estate assets at fair
value (as investment property) and others at historical cost (as owner-occupied assets), depending on
the significance of the ancillary services provided. Many believe that this is an undesirable mixed model
and have asked the FASB to consider revising its definition of investment properties to include hotels and
health care properties.
The real estate community is awaiting the FASB’s decision about investment property accounting. Its
decision will determine whether entities need to focus on the requirements and impact of fair value
reporting in addition to the effects of the new lease accounting guidance.
Revenue Recognition
As discussed in Section 1, the FASB and the IASB have jointly developed and issued an ED on revenue
recognition. While the ED does not apply specifically to real estate, it will supersede the guidance on sales
of real estate in ASC 360-20. As a result, industry-specific guidance will be replaced with a “one-sizefits-all” model based on principles rather than on the rules that govern real estate sales today.
Specific elements of the new revenue recognition model that will affect the real estate industry are:
•
The elimination of bright-line tests for assessing adequacy of the buyer’s initial investment.
•
Uncertainties about the collectability of sales prices will affect the measurement of revenue but
not necessarily the recognition of revenue.
•
Sellers will need to use judgment in assessing the significance of continuing involvement and its
impact on revenue recognition.
•
An assessment is required of whether a transfer of control has occurred in the determination of
whether a sale can be recognized.
Section 7: Real Estate Sector Supplement 121
Impairment
Real estate owners and operators have recorded and may continue to record material impairment charges.
As a result, identifying, measuring, recording, and disclosing impairments remain relevant issues in the real
estate sector.
Impairment Disclosures
In light of the impairment disclosure requirements in ASC 360-10-50-2 and ASC 820-10-50-5, the SEC
staff has frequently requested that registrants provide robust disclosure of the (1) facts and circumstances
that led to impairment, (2) the valuation technique and inputs registrants used in determining fair value,
and (3) the level of the input used within the fair value hierarchy. Such disclosures might include:
•
The specific facts and circumstances that occurred during the current period that resulted in
the identification of an impairment indicator and the determination that the property tested for
impairment was not recoverable.
•
The extent of involvement of third-party specialists (appraisers) in determining fair value.
•
The extent of reliance on internally developed models in the fair value estimates.
•
The specific discount rates, or range of rates, used.
•
A sensitivity analysis of the impact of changes to key assumptions.
Early-Warning Disclosures
The timing of impairment charges continues to be frequently challenged by regulators and others, so
early-warning disclosures in MD&A should be thorough and specific if there are potential losses on the
horizon. We understand that the SEC staff will continue to ask for more disclosures in MD&A about what
the conditions that resulted in impairments mean to the registrant’s business as well as for more forwardlooking information about the risk of future impairments. Any known trends or uncertainties that entities
reasonably expect to result in a material impact on impairment losses before the actual charges are
announced should be disclosed as soon as they are known.
Long-Lived Assets Under Development
While a property is under development, entities use the “held-and-used” model to evaluate potential
impairment. Under the held-and-used model, an impairment loss is recognized when the carrying amount
of the long-lived asset is not recoverable and exceeds its fair value. The carrying amount of a long-lived
asset is not recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the
use and the eventual disposition of the asset.
Once a long-lived asset being developed for sale is completed and ready for sale in its current condition,
the reporting entity uses the “held-for-sale” model to evaluate the assets for impairment. Under the
held-for-sale impairment model, an impairment loss must be recognized if the carrying amount of the
long-lived asset exceeds its fair value less cost to sell. Because of the different models, it is possible for
long-lived assets under development to be deemed not impaired until completion and then, immediately
upon completion, become impaired and require a write-down. As a result, the SEC staff has asked
developers to provide early-warning disclosures if current sales transactions indicate that the projected
carrying amount of properties under development is expected to exceed their fair values less costs to sell
once the project is completed.
Section 7: Real Estate Sector Supplement 122
Appendix A
Abbreviations
Appendix A: Abbreviations
Abbreviation
Description
ABS
asset-backed securities
AICPA
American Institute of Certified Public Accountants
APR
annual percentage rate
ARM
adjustable rate mortgage
ASC
FASB Accounting Standards Codification
ASU
FASB Accounting Standards Update
ATM
automated teller machine
AUM
assets under management
CAQ
Center for Audit Quality (affiliated with the AICPA)
C&DI
SEC Compliance and Disclosure Interpretation
CDO
collateralized debt obligation
CFE
collateralized financing entity
CFO
chief financial officer
CLO
collateralized loan obligation
CP
commercial paper
DAC
deferred acquisition cost
DP
discussion paper
EAP
Expert Advisory Panel
ED
exposure draft
EIR
effective interest rate
EITF
FASB’s Emerging Issues Task Force
EPS
earnings per share
ERM
enterprise risk management
FAQ
frequently asked question
FAS
Financial Accounting Standard
FASB
Financial Accounting Standards Board
FDIC
Federal Deposit Insurance Corporation
FINRA
Financial Industry Regulatory Authority
FIO
Federal Insurance Office
123
Appendix A: Abbreviations
FSOC
Financial Stability Oversight Council
FV-NI
fair value through net income
FV-OCI
fair value through other comprehensive income
FVO
fair value option
GAAP
generally accepted accounting principles
GIPS
global investment performance standards
HAMP
Home Affordable Modification Program
IAIS
International Association of Insurance Supervisors
IARD
Investment Advisory Registration Depository
IAS
International Accounting Standards
IASB
International Accounting Standards Board
ICFR
internal control over financial reporting
IFRS
International Financial Reporting Standard
IIPRC
Interstate Insurance Product Regulation Commission
LSA
loss-sharing arrangement
MD&A
Management’s Discussion and Analysis
NAIC
National Association of Insurance Commissioners
NASD
National Association of Securities Dealers
NAV
net asset value per share
NCI
noncontrolling interest
NEO
named executive officer
NIPR
National Insurance Producer Registry
NMS
national market system
NRRA
Nonadmitted and Reinsurance Reform Act
NRSRO
nationally recognized statistical rating organizations
NYSE
New York Stock Exchange
OCI
other comprehensive income
OREO
other real estate owned
ORSA
own risk solvency assessment
OTC
over the counter
124
Appendix A: Abbreviations
OTTI
other-than-temporary impairment
PAC
political action committee
PCAOB
Public Company Accounting Oversight Board
PPACA
Patient Protection and Affordable Care Act
QSPE
qualifying special-purpose entity
RAA
retained asset account
SAS
Statement on Auditing Standard
SEC
Securities and Exchange Commission
SERFF
System for Electronic Rate and Form Filing
SIC
IASB’s Standing Interpretations Committee
SIPC
Securities Investor Protection Corporation
SIV
structured investment vehicle
SMI
NAIC Solvency Modernization Initiative
SPE
special-purpose entity
SRO
self-regulatory organization
STAT
stranger-originated annuity transaction
STOA
science and technology options assessment
STOLI
stranger-originated life insurance transaction
TDR
troubled debt restructuring
TIS
AICPA Technical Questions and Answers
TPA
Technical Practice Aid
UPB
unpaid principal balance
VIE
variable interest entity
VRG
Valuation Resource Group
XBRL
eXtensible Business Reporting Language
125
Appendix B
Glossary of Topics, Standards, and Regulations
Readers seeking additional information about the topics discussed in this publication and other activities
of key standard-setters and regulators may find information on the following Web sites:
•
The FASB Web site at www.fasb.org
•
The SEC Web site at www.sec.gov
•
The PCAOB Web site at www.pcaobus.org
•
The AICPA Web site at www.aicpa.org
•
The IFRS Web site at www.ifrs.org
The following represents a listing of technical resources used in drafting this document:
FASB Accounting Standards Codification Topic 310, Receivables
FASB Accounting Standards Codification Subtopic 310-10, Receivables: Overall
FASB Accounting Standards Codification Subtopic 310-20, Receivables: Nonrefundable Fees and Other
Costs
FASB Accounting Standards Codification Subtopic 310-30, Receivables: Loans and Debt Securities
Acquired With Deteriorated Credit Quality
FASB Accounting Standards Codification Subtopic 310-40, Receivables: Troubled Debt Restructurings by
Creditors
FASB Accounting Standards Codification Subtopic 320-10, Investments — Debt and Equity Securities:
Overall
FASB Accounting Standards Codification Topic 323, Investments — Equity Method and Joint Ventures
FASB Accounting Standards Codification Subtopic 340-20, Other Assets and Deferred Costs: Capitalized
Advertising Costs
FASB Accounting Standards Codification Topic 360, Property, Plant, and Equipment
FASB Accounting Standards Codification Subtopic 360-10, Property, Plant, and Equipment: Overall
FASB Accounting Standards Codification Subtopic 360-20, Property, Plant, and Equipment: Real Estate
Sales
FASB Accounting Standards Codification Topic 405, Liabilities
FASB Accounting Standards Codification Topic 460, Guarantees
FASB Accounting Standards Codification Topic 470, Debt
FASB Accounting Standards Codification Subtopic 470-50, Debt: Modifications and Extinguishments
FASB Accounting Standards Codification Subtopic 470-60, Debt: Troubled Debt Restructurings by Debtors
FASB Accounting Standards Codification Subtopic 480-10, Distinguishing Liabilities From Equity: Overall
Appendix B: Glossary of Topics, Standards, and Regulations
126
FASB Accounting Standards Codification Topic 718, Compensation — Stock Compensation
FASB Accounting Standards Codification Subtopic 718-10, Compensation — Stock Compensation: Overall
FASB Accounting Standards Codification Topic 805, Business Combinations
FASB Accounting Standards Codification Subtopic 805-20, Business Combinations: Identifiable Assets and
Liabilities, and Any Noncontrolling Interest
FASB Accounting Standards Codification Subtopic 805-30, Business Combinations: Goodwill or Gain From
Bargain Purchase, Including Consideration Transferred
FASB Accounting Standards Codification Subtopic 805-10, Business Combinations: Overall
FASB Accounting Standards Codification Topic 810, Consolidation
FASB Accounting Standards Codification Subtopic 810-10, Consolidation: Overall
FASB Accounting Standards Codification Topic 815, Derivatives and Hedging
FASB Accounting Standards Codification Subtopic 815-10, Derivatives and Hedging: Overall
FASB Accounting Standards Codification Subtopic 815-15, Derivatives and Hedging: Embedded Derivatives
FASB Accounting Standards Codification Topic 820, Fair Value Measurements and Disclosures
FASB Accounting Standards Codification Subtopic 820-10, Fair Value Measurements and Disclosures:
Overall
FASB Accounting Standards Codification Topic 825, Financial Instruments
FASB Accounting Standards Codification Subtopic 825-10, Financial Instruments: Overall
FASB Accounting Standards Codification Topic 840, Leases
FASB Accounting Standards Codification Topic 850, Related Party Disclosures
FASB Accounting Standards Codification Subtopic 850-10, Related Party Disclosures: Overall
FASB Accounting Standards Codification Topic 855, Subsequent Events
FASB Accounting Standards Codification Subtopic 855-10, Subsequent Events: Overall
FASB Accounting Standards Codification Topic 860, Transfers and Servicing
FASB Accounting Standards Codification Subtopic 860-10, Transfers and Servicing: Overall
FASB Accounting Standards Codification Subtopic 942-320, Financial Services — Depository and Lending:
Investments — Debt and Equity Securities
FASB Accounting Standards Codification Topic 944, Financial Services — Insurance
FASB Accounting Standards Codification Subtopic 944-30, Financial Services — Insurance: Acquisition
Costs
Appendix B: Glossary of Topics, Standards, and Regulations
127
FASB Accounting Standards Codification Subtopic 944-80, Financial Services — Insurance: Separate
Accounts
FASB Accounting Standards Codification Topic 946, Financial Services — Investment Companies
FASB Accounting Standards Codification Subtopic 946-10, Financial Services — Investment Companies:
Overall
FASB Accounting Standards Update No. 2010-20, Disclosures About the Credit Quality of Financing
Receivables and the Allowance for Credit Losses
FASB Accounting Standards Update No. 2010-18, Effect of a Loan Modification When the Loan Is Part of
a Pool That Is Accounted for as a Single Asset
FASB Accounting Standards Update No. 2010-11, Scope Exception Related to Embedded Credit
Derivatives
FASB Accounting Standards Update No. 2010-10, Amendments for Certain Investment Funds
FASB Accounting Standards Update No. 2010-09, Amendments to Certain Recognition and Disclosure
Requirements
FASB Accounting Standards Update No. 2010-06, Improving Disclosures About Fair Value Measurements
FASB Accounting Standards Update No. 2010-01, Accounting for Distributions to Shareholders With
Components of Stock and Cash
FASB Accounting Standards Update No. 2009-17, Improvements to Financial Reporting by Enterprises
Involved With Variable Interest Entities
FASB Accounting Standards Update No. 2009-16, Accounting for Transfers of Financial Assets
FASB Accounting Standards Update No. 2009-15, Accounting for Own-Share Lending Arrangements in
Contemplation of Convertible Debt Issuance or Other Financing
FASB Accounting Standards Update No. 2009-12, Investments in Certain Entities That Calculate Net Asset
Value per Share (or Its Equivalent)
Proposed FASB Accounting Standards Update, Accounting for Financial Instruments and Revisions to the
Accounting for Derivative Instruments and Hedging Activities
Proposed FASB Accounting Standards Update, Amendments for Common Fair Value Measurement and
Disclosure Requirements in U.S. GAAP and IFRSs
Proposed FASB Accounting Standards Update, Clarifications to Accounting for Troubled Debt
Restructurings by Creditors
Proposed FASB Accounting Standards Update, Disclosure of Certain Loss Contingencies
Proposed FASB Accounting Standards Update, Revenue From Contracts With Customers
Proposed FASB Accounting Standards Update, Statement of Comprehensive Income
FASB Statement No. 167, Amendments to FASB Interpretation No. 46(R)
Appendix B: Glossary of Topics, Standards, and Regulations
128
FASB Statement No. 166, Accounting for Transfers of Financial Assets — an Amendment of FASB
Statement No. 140
FASB Statement No. 157, Fair Value Measurements
FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities — a Replacement of FASB Statement No 125
FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities
FASB Statement No. 130, Reporting Comprehensive Income
FASB Interpretation No. 46(R), Consolidation of Variable Interest Entities — an Interpretation of ARB No.
51
EITF Issue No. 09-G, “Accounting for Costs Associated With Acquiring or Renewing Insurance Contracts”
EITF Issue No. 09-E, “Accounting for Stock Dividends, Including Distributions to Shareholders With
Components of Stock and Cash”
EITF Issue No. 09-B, “Consideration of an Insurer’s Accounting for Majority-Owned Investments When
Ownership Is Through a Separate Account”
EITF Issue No. 09-1, “Accounting for Own-Share Lending Arrangements in Contemplation of Convertible
Debt Issuance”
SEC Regulation S-X, Rule 3A-02, “Consolidated Financial Statements of the Registrant and Its Subsidiaries”
SEC Regulation S-K, Item 10(e), “Use of Non-GAAP Financial Measures in Commission Filings”
SEC Regulation S-K, Item 303, “Management’s Discussion and Analysis of Financial Condition and Results
of Operations”
SEC Final Rule Release No. 34-63241, Risk Management Controls for Brokers or Dealers With Market
Access
SEC Final Rule Release No. 34-62184A, Amendment to Municipal Securities Disclosure
SEC Final Rule Release No. 34-61595, Amendments to Regulation SHO
SEC Final Rule Release No. 33-9142, Internal Control Over Financial Reporting in Exchange Act Periodic
Reports of Non-Accelerated Filers (effective September 21, 2010)
SEC Final Rule Release No. 33-9134, Notice of Solicitation of Public Comment on Consideration of
Incorporating IFRS Into the Financial Reporting System for U.S. Issuers
SEC Final Rule Release No. 33-9133, Notice of Solicitation of Public Comment on Consideration of
Incorporating IFRS Into the Financial Reporting System for U.S. Issuers
SEC Final Rule Release No. 33-9072, Internal Control Over Financial Reporting in Exchange Act Periodic
Reports of Non-Accelerated Filers
SEC Final Rule Release No. IA-3060, Amendments to Form ADV
Appendix B: Glossary of Topics, Standards, and Regulations
129
SEC Final Rule Release No. IA-3043, Political Contributions by Certain Investment Advisers
SEC Final Rule Release No. IA-2968, Custody of Funds or Securities of Clients by Investment Advisers
SEC Final Rule Release No. IC-29132, Money Market Fund Reform
SEC Proposed Rule Release No. 34-62445, Elimination of Flash Order Exception From Rule 602 of
Regulation NMS
SEC Proposed Rule Release No. 34-61902, Proposed Amendments to Rule 610 of Regulation NMS
SEC Proposed Rule Release No. 33-9150, Issuer Review of Assets in Offerings of Asset-Backed Securities
SEC Proposed Rule Release No. 33-9148, Disclosure for Asset-Backed Securities Required by Section 943
of the Dodd-Frank Wall Street Reform and Consumer Protection Act
SEC Proposed Release Rule No. 33-9143, Short-Term Borrowings Disclosure
SEC Proposed Rule Release No. 33-9117, Asset-Backed Securities
SEC Proposed Rule Release No. IA-1862, Electronic Filing by Investment Advisers; Proposed Amendments
to Form ADV
SEC Interpretive Release No. 33-9144, Commission Guidance on Presentation of Liquidity and Capital
Resources Disclosures in Management’s Discussion and Analysis
Securities Exchange Act of 1934, Rule 15c3-1, “Net Capital Requirements for Brokers or Dealers”
Financial Industry Regulatory Authority (FINRA) Rule 4110, “Capital Compliance”
Valuation Resource Group (VRG) Issue No. 2010-01, “FASB/IASB’s Joint Project on Fair Value Measurement
and Disclosure”
Office of Thrift Supervision, Thrift Bulletin 85, “Regulatory and Accounting Issues Related to Modifications
and Troubled Debt Restructurings of 1-4 Residential Mortgage Loans”
IFRS 4, Insurance Contracts
IFRS 7, Financial Instruments: Disclosures
IFRS 9, Financial Instruments
IAS 27, Consolidated and Separate Financial Statements
IAS 32, Financial Instruments: Presentation
IAS 39, Financial Instruments: Recognition and Measurement
IAS 40, Investment Property
SIC-12, Consolidation — Special Purpose Entities
IASB Exposure Draft ED10, Consolidated Financial Statements
IASB Exposure Draft ED/2009/3, Derecognition: Proposed Amendments to IAS 39 and IFRS 7
Appendix B: Glossary of Topics, Standards, and Regulations
130
FASB Accounting Standards Codification
General Principles
470 – Debt
105 – Generally Accepted Accounting Principles
480 – Distinguishing Liabilities From Equity (FAS 150)
Equity
Presentation
505 – Equity
205 – Presentation of Financial Statements
Revenue
210 – Balance Sheet
605 – Revenue Recognition
215 – Statement of Shareholder Equity
Expenses
220 – Comprehensive Income (FAS 130)
705 – Cost of Sales and Services
225 – Income Statement
710 – Compensation — General
230 – Statement of Cash Flows (FAS 95)
712 – Compensation — Nonretirement Postemployment
Benefits (FAS 112)
235 – Notes to Financial Statements
250 – Accounting Changes and Error Corrections (FAS 154)
255 – Changing Prices
260 – Earnings per Share (FAS 128)
270 – Interim Reporting (APB 28)
272 – Limited Liability Entities
274 – Personal Finance Statements
275 – Risks and Uncertainties
280 – Segment Reporting (FAS 131)
Financial Statement Line Item
Assets
305 – Cash and Cash Equivalents
310 – Receivables
320 – Investments — Debt and Equity Securities (FAS 115)
323 – Investments — Equity Method and Joint Ventures
(APB 18)
325 – Investments — Other
330 – Inventory
340 – Other Assets and Deferred Costs
350 – Intangibles — Goodwill and Other (FAS 142)
360 – Property, Plant, and Equipment (FAS 144)
Liabilities
405 – Liabilities
715 – Compensation — Retirement Benefits (FAS 87; 88;
106; 112; 132(R); 158)
718 – Compensation — Stock Compensation (FAS 123(R))
720 – Other Expenses
730 – Research and Development (FAS 2)
740 – Income Taxes (FAS 109/FIN 48)
Broad Transactions
805 – Business Combinations (FAS 141(R))
808 – Collaborative Arrangements
810 – Consolidation (FIN 46(R)/ARB 51/FAS 160)
815 – Derivatives and Hedging (FAS 133)
820 – Fair Value Measurements and Disclosures (FAS 157)
825 – Financial Instruments (FAS 159)
830 – Foreign Currency Matters (FAS 52)
835 – Interest
840 – Leases (FAS 13)
845 – Nonmonetary Transactions (APB 29)
850 – Related Party Disclosures
852 – Reorganizations
855 – Subsequent Events (FAS 165)
860 – Transfers and Servicing (FAS 140)
Industry
410 – Asset Retirement and Environmental Obligations (FAS
143)
905 – Agriculture
420 – Exit or Disposal Cost Obligations (FAS 146)
910 – Contractors — Construction
430 – Deferred Revenue
912 – Contractors — Federal Government
440 – Commitments
915 – Development Stage Entities
450 – Contingencies (FAS 5)
920 – Entertainment — Broadcasters
460 – Guarantees (FIN 45)
922 – Entertainment — Cable Television
Appendix B: Glossary of Topics, Standards, and Regulations
908 – Airlines
131
924 – Entertainment — Casinos
958 – Not-for-Profit Entities
926 – Entertainment — Films
960 – Plan Accounting — Defined Benefit Pension Plans
928 – Entertainment — Music
930 – Extractive Activities — Mining
962 – Plan Accounting — Defined Contribution Pension
Plans
932 – Extractive Activities — Oil and Gas
965 – Plan Accounting — Health and Welfare Benefit Plans
940 – Financial Services — Broker and Dealers
970 – Real Estate — General
942 – Financial Services — Depository and Lending
972 – Real Estate — Common Interest Realty Associations
944 – Financial Services — Insurance
974 – Real Estate — Real Estate Investment Trusts
946 – Financial Services — Investment Companies
976 – Real Estate — Retail Land
948 – Financial Services — Mortgage Banking
978 – Real Estate — Time-Sharing Activities
950 – Financial Services — Title Plant
980 – Regulated Operations
952 – Franchisors
985 – Software
954 – Health Care Entities
995 – U.S. Steamship Entities
956 – Limited Liability Entities
Appendix B: Glossary of Topics, Standards, and Regulations
132
Appendix C
Deloitte Specialists and Acknowledgments
U.S. Financial Services Industry
Jim Reichbach | Vice Chairman, Financial Services | Deloitte LLP
+1 212 436 5730 | jreichbach@deloitte.com
Susan L. Freshour | Financial Services Industry Professional Practice Director | Deloitte & Touche LLP
+1 212 436 4814 | sfreshour@deloitte.com
Howard Kaplan | Financial Instrument Valuation and Securitization Leader | Deloitte & Touche LLP
+1 212 436 2163 | hkaplan@deloitte.com
Tom Omberg | Financial Accounting and Reporting Services Leader | Deloitte & Touche LLP
+1 212 436 4126 I tomberg@deloitte.com
Kevin McGovern | Governance, Risk and Regulatory Consulting Services Leader | Deloitte & Touche LLP
+1 617 437 2371 | kmcgovern@deloitte.com
Rhoda Woo | Financial Services Industry Enterprise Risk Leader | Banking and Securities Enterprise
Risk Leader | Deloitte & Touche LLP
+1 212 436 3388 | rwoo@deloitte.com
Asset Management Industry
Cary Stier | Practice Leader, Asset Management Services | Deloitte & Touche LLP
+1 312 486 3274 | cstier@deloitte.com
Rob Fabio | Asset Management Industry Professional Practice Director | Deloitte & Touche LLP
+1 212 436 5492 | rfabio@deloitte.com
Brian Gallagher | Asset Management Industry Professional Practice Director | Deloitte & Touche LLP
+1 617 437 2398 | bgallagher@deloitte.com
Donna Glass | Asset Management Enterprise Risk Leader | Deloitte & Touche LLP
+1 212 436 6408 | dglass@deloitte.com
Banking and Securities Industry
Bob Contri | Practice Leader, Banking and Securities Industry | Deloitte LLP
+1 212 436 2043 | bcontri@deloitte.com
Chris Donovan | Securities Industry Professional Practice Director | Deloitte & Touche LLP
+1 212 436 4478 | chrdonovan@deloitte.com
Dipti Gulati | Securities Industry Professional Practice Director | Deloitte & Touche LLP
+1 212 436 5509 | dgulati@deloitte.com
Hugh Guyler | Banking and Finance Companies Industry Professional Practice Director |
Deloitte & Touche LLP
+1 212 436 4848 | hguyler@deloitte.com
Jim Mountain | Banking and Finance Companies Industry Professional Practice Director |
Deloitte & Touche LLP
+1 212 436 4742 | jmountain@deloitte.com
Appendix C: Deloitte Specialists and Acknowledgments
133
Insurance Industry
Rebecca C. Amoroso | Practice Leader, Insurance Services | Deloitte LLP
+1 973 602 5385 | ramoroso@deloitte.com
Mark Parkin | Insurance Enterprise Risk Leader | Deloitte & Touche LLP
+1 212 436 4761 | mparkin@deloitte.com
Don Schwegman | Insurance Industry Professional Practice Director | Deloitte & Touche LLP
+1 513 784 7307 | dschwegman@deloitte.com
Rick Sojkowski | Insurance Industry Professional Practice Director | Deloitte & Touche LLP
+1 860 725 3094| rsojkowski@deloitte.com
Real Estate Industry
Bob O’Brien | Practice Leader, Real Estate Services | Deloitte LLP
+1 312 486 2717 | robrien@deloitte.com
Chris Dubrowski | Real Estate Industry Professional Practice Director | Deloitte & Touche LLP
+1 203 708 4718 | cdubrowski@deloitte.com
Jim Berry | Real Estate Enterprise Risk Leader | Deloitte & Touche LLP
+1 214 840 7360| jiberry@deloitte.com
Acknowledgments
We would like to thank the following Deloitte professionals for contributing to this document:
Teri Asarito
Chris Donovan
Derek Hodgdon
Karen Bartos
Chris Dubrowski
Lyndsey Hoehn
Bryan Benjamin
David Elizandro
Sherrelle Jemmott
Mark Bolton
Carolyn Estrada
Steve Joyce
Damien Browne
Rob Fabio
Robert Jurinek
Hilary Cabodi
Susan Freshour
Elizabeth Kim
Lynne Campbell
Brian Gallagher
Joanna Klocek
Erin Carberry
Irena Gecas-McCarthy
Elizabeth Krentzman
Melissa Card
Gina Greer
Katie Kuperus
Clayton Chandler
Jesselyn Greiner
Ken Loo
Danielle Chase
Dipti Gulati
Tania Lynn
Janet Cuccinelli
Dmitriy Gutman
Jim May
Mike Chung
Hugh Guyler
Adrian Mills
Amy Diehl
George Hanley
Jim Mountain
Joe DiLeo
Rich Hildebrand
Rob Moynihan
Appendix C: Deloitte Specialists and Acknowledgments
134
Samuel Mulliner
Yvonne Rudek
Andrew Spooner
Jeff Nickell
John Sarno
Anastasia Traylor
Magnus Orrell
Patrick Scheibel
Mark Trousdale
Jeanine Pagliaro
Don Schwegman
Adam Vanfossen
Kirtan Parikh
Khalid Shah
Ping Wang
Jay Regan
Shahid Shah
Wes Yeomans
Joseph Renouf
Vicki Shekhtmeyster
Lynne Robertson
Rick Sojkowski
Appendix C: Deloitte Specialists and Acknowledgments
135
Appendix D
Other Resources
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Appendix D: Other Resources
136
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